ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2012

OR

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 333-175270-07

GUITAR CENTER HOLDINGS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware

26-0843262

(State or Other Jurisdiction of

Incorporation or Organization)

(I.R.S. Employer Identification No.)

5795 Lindero Canyon Road

Westlake Village, California 91362

(818) 735-8800

(Address of Principal Executive Offices, including Zip Code)

(Registrants Telephone Number, Including Area Code)

Commission File Number 000-22207

GUITAR CENTER, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware

95-4600862

(State or Other Jurisdiction of

Incorporation or Organization)

(I.R.S. Employer Identification No.)

5795 Lindero Canyon Road

Westlake Village, California 91362

(818) 735-8800

(Address of Principal Executive Offices, including Zip Code)

(Registrants Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act:

Guitar Center Holdings, Inc. (Holdings)

None

Guitar Center, Inc. (Guitar Center)

None

Securities registered pursuant to Section 12(g) of the Act:

Holdings

None

Guitar Center

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Holdings

YES o NO x

Guitar Center

YES o NO x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Holdings

YES x NO o

Guitar Center

YES x NO o

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Holdings*

YES o NO o

Guitar Center*

YES o NO o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Holdings

YES x NO o

Guitar Center

YES x NO o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

Holdings

x

Guitar Center

x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act:

Holdings

Large accelerated filer o

Accelerated filer o

Non-accelerated filer x

Smaller reporting company o

(Do not check if a smaller reporting company)

Guitar Center

Large accelerated filer o

Accelerated filer o

Non-accelerated filer x

Smaller reporting company o

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.)

Holdings

YES o NO x

Guitar Center

YES o NO x

As of June 30, 2012, there was no established public trading market for any of the common stock of Holdings or Guitar Center.

As of March 15, 2013, there were 9,740,160 shares of common stock, $0.01 par value per share, of Holdings outstanding.

As of March 15, 2013, there were 100 shares of common stock, $0.01 par value per share, of Guitar Center outstanding, all of which are owned by Holdings.

*The registrants have filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934, but are not required to file such reports under such sections.

This Annual Report on Form 10-K is a combined annual report being filed by Guitar Center, Inc. (Guitar Center) and Guitar Center Holdings, Inc. (Holdings). Guitar Center is a direct, wholly-owned subsidiary of Holdings. Each of Guitar Center and Holdings is filing on its own behalf all of the information contained in this annual report that relates to such company. Where information or an explanation is provided that is substantially the same for each company, such information or explanation has been combined in this annual report. Where information or an explanation is not substantially the same for each company, separate information and explanation has been provided. In addition, separate consolidated financial statements for each company are included in this annual report.

The following discussion, as well as other portions of this annual report, contains forward-looking statements that reflect our plans, estimates and beliefs. Any statements (including, but not limited to, statements to the effect that we or our management anticipate, plan, estimate, expect, believe, intend, and other similar expressions) that are not statements of historical fact should be considered forward-looking statements and should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this annual report. Specific examples of forward-looking statements include, but are not limited to, statements regarding our forecasts of financial performance, capital expenditures, working capital requirements and forecasts of effective tax rates. Our actual results could materially differ from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed below and elsewhere in this annual report, and particularly in Risk Factors.

Unless otherwise indicated or the context otherwise requires, the terms we, us, the Company, Guitar Center, our and other similar terms refer to the business of Guitar Center, Inc. and its consolidated subsidiaries, and the term Holdings refers to Guitar Center Holdings, Inc. and its subsidiaries. With respect to information regarding the terms of our 11.50% senior notes due 2017 (the senior notes), the term Guitar Center refers only to Guitar Center, Inc. and not to any of its subsidiaries. With respect to information regarding the terms of our 14.09% senior PIK notes due 2018 (the senior PIK notes and, together with the senior notes, the notes), Holdings refers only to Guitar Center Holdings, Inc. and not to any of its subsidiaries.

Overview

Introduction

We are the leading retailer of music products in the United States. We operate three business units under our Guitar Center, direct response and Music & Arts brands. Our Guitar Center brand offers guitars, amplifiers, percussion instruments, keyboards and pro audio and recording equipment through our retail stores and online, along with repair services and a limited number of rehearsal and lesson services. Our direct response brands offer catalog and online sales of a broad selection of music products under various brand names, including Musicians Friend, Music123 and Woodwind & Brasswind. Our Music & Arts brand offers band and orchestra instruments for rental and sale, music lessons and a limited selection of products of the type offered by our Guitar Center stores.

Guitar Center Holdings, Inc. is Guitar Centers parent company and has no material assets or operations other than its ownership of Guitar Center, Inc. and related debt and equity financing activities.

On October 9, 2007, Holdings, a company controlled by an affiliate of Bain Capital Partners, LLC (Bain Capital), acquired Guitar Center in a transaction having an aggregate value of approximately $2.1 billion, excluding fees and expenses. The acquisition was effected through the merger of VH MergerSub, Inc. (Merger Sub), a wholly owned subsidiary of Holdings, with and into Guitar Center, which was the surviving corporation. Immediately following the merger, Guitar Center became a wholly owned direct subsidiary of Holdings.

Holdings is owned by investment funds associated with Bain Capital, a co-investor and certain members of our senior management (the management investors), to whom we refer collectively as the equity investors.

The acquisition resulted in the occurrence of the following events, which we refer to collectively as the Transactions:

·the purchase by the equity investors of equity interests of Holdings for approximately $625.0 million in cash and/or, with respect to the management investors, through a roll-over of existing Guitar Center equity;

·the entering into by Merger Sub of the senior secured credit facilities, consisting of a $650.0 million term loan and a $375.0 million asset-based senior secured revolving credit facility, of which approximately $148.2 million was drawn at closing;

·the entering into by Merger Sub of a senior unsecured initial loan consisting of a $375.0 million term loan;

·the entering into by Holdings of a senior unsecured initial loan consisting of a $375.0 million term loan;

·the refinancing of our historical debt, including accrued and unpaid interest, of approximately $161.3 million;

·the merger of Merger Sub with and into Guitar Center, with Guitar Center as the surviving corporation, and the payment of the related merger consideration; and

·the payment of approximately $66.4 million of fees and expenses related to the Transactions.

As a result of the merger, all obligations of Merger Sub under the senior secured credit facilities and the senior unsecured initial loan became obligations of Guitar Center.

Guitar Center

Our Guitar Center stores offer an interactive, hands-on shopping experience with an emphasis on customer service and a broad selection of brand-name, high quality products at competitive prices. We believe we create an entertaining and exciting atmosphere in our stores with bold and dramatic merchandise presentations arranged by product category to create a shop within a shop customer experience. Customers can obtain technical information and relevant insight from sales personnel and are encouraged to try products on display. We believe that a significant portion of our Guitar Center store sales are to professional and aspiring-professional musicians who generally view the purchase of music products as a career necessity. These sophisticated customers rely on our knowledgeable salespeople to answer technical questions, provide advice and assist in product demonstrations.

As of March 15, 2013, we operated 244 Guitar Center stores in 44 states, consisting of 151 primary format stores, 80 secondary format stores and 13 tertiary format stores. The store format is determined primarily by the size of the market in which it is located. Our primary format stores serve major metropolitan population centers and generally range in size from 13,000 to 30,000 square feet. Our secondary format stores serve metropolitan areas not served by our primary format stores and generally range in size from 8,000 to 15,000 square feet. Tertiary market stores serve smaller population centers and generally range in size from 5,000 to 8,000 square feet. We also operate one lesson and rehearsal facility in Southern California under the GC Studios name. Rehearsal and lesson space is included in some of our newer and newly remodeled stores.

Guitar Center also offers online sales and research through its website. This online channel creates a multi-channel Guitar Center business that allows customers to interact between the brick-and-mortar and online operations.

Our Guitar Center stores are supported by a distribution facility located near Indianapolis, Indiana.

Our direct response business operates a direct response e-commerce and catalog business, offering a shopping experience that includes technical product information, quick and efficient sales and service and a musician-based staff for pre- and post-sale support. Our direct response business includes catalogs and websites under various brands, including Musicians Friend, Music123 and Woodwind & Brasswind.

Our direct response business is supported by customer contact centers located in Salt Lake City, Utah, and Indianapolis, Indiana, and an order fulfillment facility located in Kansas City, Missouri.

Music & Arts

Our Music & Arts business operates stores specializing in band and orchestra instruments for sale and rental to students, teachers, band directors and college professors. Most of our Music & Arts stores also sell a limited assortment of guitars, amplifiers, percussion instruments and keyboards, as well as provide in-store music lessons. Music & Arts instrument rentals are conducted on-site at schools through our outbound education representatives, over-the-counter at our retail locations and through affiliated stores operated by third parties.

Our Music & Arts business is a leading retailer of musical products to students and beginner musicians with 110 stores in 22 states as of March 15, 2013. Music & Arts also has approximately 126 education representatives who are employees and 345 active affiliate locations, who together with in-store rentals generated approximately 278,000 new rental contracts in 2012. Our Music & Arts stores generally range in size from 800 to 6,800 square feet, with an average store size of approximately 3,100 square feet. Music & Arts also operates online through its website.

Our Music & Arts business is headquartered in Frederick, Maryland and is supported there by a distribution facility.

Industry

The marketplace has changed significantly since we opened in 1964. Musical instruments and accessories historically have been sold through small, local, mom and pop stores. Todays marketplace is much more sophisticated. Our stores and websites compete against other large and small musical instrument retailers, online music retailers, online auctions, direct-to-consumer alternatives and a number of large mass merchants.

The consumer landscape for musical products is more diverse, with each category of musician having different expectations, price sensitivities, purchasing habits and approaches to music. Customers are not satisfied with one-size fits all offerings. Further, musical instruments comprise a broad range of products each with their own underlying trends, including not only traditional products like guitars and drums, but also newer technology-intensive products like home recording equipment.

Over the past decade, technological advances in the music industry have resulted in dramatic changes in the nature of many music-related products. Manufacturers have combined computers and microprocessor technologies with musical equipment to create a new generation of products capable of high-grade sound processing and reproduction. Products featuring those technologies are available in a variety of forms and have broad application across most music product categories.

Technological innovation and the internet continue to increase the accessibility of producing, distributing and consuming music. Today, many musicians can affordably create a home recording studio that interacts with a personal computer and is capable of producing high-quality digital recordings. Historically, this type of powerful sound processing capability was prohibitively expensive and was purchased primarily by professional sound recording studios. In addition, musicians have evolving new distribution channels for their music, such as online music stores and social media websites. These new distribution channels have dramatically altered the music distribution business by providing musicians with more direct and low cost channels to reach potential listeners, compared to the traditional record company distribution business model.

Continue to grow our Guitar Center brand. We are focused on improving the productivity of our Guitar Center brand through opening new stores, enhancing our multi-channel capabilities and offering additional services to musicians such as repairs, lessons and rehearsal space. We intend to devote significant resources to enhancing the multi-channel coordination between our in-store and online sales strategies. We will also continue to implement our logistics, systems and inventory management initiatives.

Enhance our sales and merchandise margins and productivity. We intend to expand our offering of proprietary products, which typically have higher profit margins when compared to branded products in corresponding categories. Our proprietary product offering historically has been focused on commodity merchandise, such as cables, bags and accessories. However, we also intend to continue to expand our proprietary product offering in less commoditized product lines.

Enhance our direct response brands. We are focused on maintaining our revenue position within our direct response brands. Our core strategies include personalization and one-to-one marketing that delivers products and services customized to the specific needs of musicians. We believe our continued focus on technology and infrastructure will enhance our direct response website user experience, improve our market responsiveness, increase our speed to market and further differentiate us from our competition. We also intend to focus the marketing and development of our direct response brands to more closely target each brands core customers and strengths.

Continue to build our Music & Arts brand. Our Music & Arts strategy includes opening additional stores and acquiring businesses, affiliates and educational representatives within this fragmented market. In addition, we intend to continue to grow the music instrument rental business, which we believe will provide us with additional opportunities to attract young musicians as customers. We believe that attracting musicians at a young age will develop brand loyalty and enhance their lifetime value to us.

Our stores are organized by product areas, with each area focused on specific products categories such as guitars, basses, amplifiers, drums and percussion, keyboards, pro audio and recording, DJ, lighting and live sound, as well as accessories, used and vintage equipment. These departments address our customers specific product needs and are staffed by specialized salespeople, many of whom also are practicing musicians. We also offer a trade-in policy that provides musicians with an alternative form of payment and the convenience of selling a used instrument and purchasing a new one at a single location. Used and vintage products are purchased and priced to sell by store managers, who are specially trained in the used musical instrument market.

Below is an overview of our principal departments:

Guitars and amplifiers. Our guitar and amplifiers department carries a wide variety of new, used and vintage electric, acoustic, classical, bluegrass and bass guitars. Major manufacturers including Fender, Gibson, Ibanez, Martin, Music Man, Ovation, PRS and Taylor are represented. A number of our stores also carry other stringed instruments such as banjos, mandolins and ukuleles. We also offer an extensive selection of guitar sound processing units and products that allow guitars to interface with a personal computer. These products serve crossover demand from the traditional guitarist into new computer-related sound products. We offer an extensive selection of electric, acoustic and bass guitar amplifiers, including a variety of boutique and vintage amplifiers. We carry amplifiers from most major manufacturers, including Ampeg, Crate, Fender, Line 6, Marshall, Mesa Boogie, Peavey and Vox.

Drums. Our drum department carries a range of percussion instruments, from drum kits to congas, bongos and other rhythmic and electronic percussion products. We also carry a selection of vintage and used percussion instruments. We carry name brands such as Drum Workshop, Gretsch, Pearl, Sabian, Tama, Yamaha and Zildjian.

Pro audio and recording. Our pro audio and recording department carries live-sound, DJ, lighting and recording equipment for musicians at every level, from the casual hobbyist to the professional recording engineer. We maintain a broad selection of computer-related recording products, including sound cards, sound libraries and composition and recording software. Our products range from recording accessories to state-of-the-art digital recording systems. We also carry a large assortment of professional stage audio, DJ and lighting equipment for small traveling bands, mobile DJs, private clubs and large touring professional bands. Our pro audio brand name manufacturers include Apple, Avid, JBL, KRK, M-Audio, Mackie, PreSonus, Roland, Shure, Sony, Tascam and Yamaha.

Direct response

Our direct response business offers merchandise through its catalogs and online through its websites. Our direct response business offers a product mix that includes the same categories as those offered by our Guitar Center stores, including guitars and amplifiers, drums, keyboard, pro audio and accessories. In addition, our direct response business offers a range of band and orchestra instruments and accessories that primarily are targeted at intermediate and professional musicians. Our direct response catalogs generally offer an average of approximately 8,000 SKUs, while approximately 51,000 SKUs are offered on our websites.

Music & Arts

Our Music & Arts business focuses on the student and family music market, particularly band and orchestra instruments. These stores offer band and orchestral instruments and related accessories for sale and rental, musical instrument lessons and a limited assortment of guitars, amplifiers, percussion instruments, and keyboards. Our Music & Arts stores offer a full range of brass, woodwind, stringed orchestra instruments and related music accessories. These stores also carry a wide range of sheet music. Name brand manufacturers carried at Music & Arts stores include Bach, Buffet, Conn, Eastman, Gemeinhardt, Jupiter, Leblanc, Ludwig, Selmer and Yamaha.

Management of brands

Guitar Center

Our Guitar Center brands are managed by an Executive Vice President and a brand manager. These operations include the multi-channel retail and online operations of the brand.

Direct response

Our direct response operations are managed by an Executive Vice President and a brand manager for each brand. Operations of the brands also include teams that focus on systems, websites functionality and user experience.

Music & Arts

Our Music & Arts business is managed by a divisional Chief Executive Officer, a divisional President, an Executive Vice President of Operations and an Executive Vice President of Sales.

Our proprietary databases are a central element of our marketing and promotion programs. We maintain three proprietary databases that we have developed for Guitar Center, direct response and Music & Arts. Included in these databases is information on millions of our customers. We believe that these databases assist us in identifying customer prospects, generating repeat business by targeting customers based on their purchasing history and establishing and maintaining personal relationships with our customers.

Guitar Center stores

Our advertising and promotion strategy for our Guitar Center stores is designed to enhance the Guitar Center name and increase customer awareness and loyalty. Our advertising and promotional campaigns generally are developed around events designed to attract significant store traffic and exposure. We regularly plan large promotional events including the Green Tag Sale, the Anniversary Sale and the Guitar-a-thon. These events often are coordinated with product demonstrations, interactive displays, clinics and in-store artist appearances. We use television advertising to supplement or promote these events and to create general brand awareness. In addition, our online channel conducts marketing and promotion through many of the same methods as our direct response business.

As we enter new markets, we initiate an advertising program, including mail and radio promotions, internet campaigns and other special grand opening activities. Each element of this advertising program is designed to accelerate sales volume for each new store.

We also maintain a variety of promotional financing alternatives for our customers. Generally, all credit made available to retail customers and all extended payment arrangements are provided by third party consumer credit companies which are non-recourse to us, such that the risk of non-payment is borne by the third party provider so long as we comply with its administrative and approval policies. These arrangements also give us the flexibility to offer attractive payment options to our customers on a promotional basis, such as interest-free periods or reduced interest rates. Promotional interest-free periods are generally offered for six to 18 months. These programs are also non-recourse to us, but we pay the credit provider a fee reflecting the below-market, promotional benefit of the particular program.

Direct response

Our direct response business maintains regular customer communication through electronic and print media. We perform an extensive analysis of customer behavior and transactions, and the industry expertise of our merchandising staff provides our marketing staff with offers that are targeted for optimal customer response. Our merchandising and marketing departments use our customer research tools to design personalized product and promotional offerings for prospective customers. We are also making significant investments in enhanced web-based analytical search engine tools and web-based direct marketing initiatives.

Our direct response strategy includes the development of catalogs targeted towards particular segments of the musician market.

Music & Arts

Our advertising efforts for the Music & Arts stores are focused primarily on the school band and orchestra market and community. For instrument rentals, advertising and promotional campaigns are developed around rental nights designed to display our orchestral and band instruments at elementary and middle schools. These events attract band directors, music educators, parents and students. Our key promotional events are held primarily from August through October. In addition to rental nights, we have outside sales education representatives to promote and educate band directors on our instruments and our sales and rental programs. We also strive to maintain long-term relationships with educators in order to provide visibility to our products and obtain access to student musicians.

Exceptional customer service is fundamental to our operating strategy. With the rapid changes in technology and continuous new product introductions, we believe that customers depend on our salespeople to offer expert advice and to assist with product demonstrations. Our employees often are musicians trained to understand the needs of our customers. Guitar Center store salespeople specialize in one of our product categories and typically begin training on their first day of employment. Guitar Center store sales and management training programs are implemented on an ongoing basis to maintain and improve the level of customer service and sales support in the stores. Support for our online customers is handled through experienced contact center staff. As a commitment to our customers, we have invested in software at our stores enabling our sales staff to keep regular contact with customers to enhance and personalize their shopping experience. We have also invested in a workforce management system to help us optimally staff our stores for peak customer traffic periods.

Direct response

Our direct response customer contact staff receives product and customer service training in our Salt Lake City, Utah and Indianapolis, Indiana contact center facilities. Extensive product information, including technical information, product features and benefits and real-time stocking information is available to the staff on their desktop systems via intranet and back-end information systems. Many of the staff are musicians who are given extensive and ongoing product training. We have full-time and part-time customer service employees staffing the contact centers 24 hours a day, seven days a week.

For customers that have registered e-mail addresses with us, we offer automated order and shipment verification. This service provides customers with UPS or FedEx order tracking information as soon as their shipment has been processed. To provide customers with a high degree of satisfaction, customers may return items for a full refund within 45 days of purchase. Additionally, if customers find a lower advertised price within 45 days of purchase, we will match the competitors advertised price.

Music & Arts

Sales at our Music & Arts business are made primarily through our education sales representatives and over the counter at our retail stores. The majority of our education representative sales force is comprised of music teachers who are experienced band and orchestra instructors. The customer service functions relating to sales made by our education representatives generally are conducted by our centralized contact center. The customer service functions relating to sales made over the counter at our retail stores generally are conducted by our retail staff, who provide a full service retail experience for our customers.

Purchasing

We believe that we have excellent relationships with our vendors and, in many instances, we are our vendors largest customer. Given our high volume, we are generally able to receive prompt order fulfillment and access to premium products and promotions.

Our shared services organization manages purchasing, inventory management and vendor relations functions for our Guitar Center and direct response brands. This group also provides pricing analysis at the request of the brands and makes recommendations based on the research of its planning team. Music & Arts maintains its own merchandising and buying groups.

Each of our brands maintains its own merchandise selection and brand pricing functions.

Our business and expansion plans are dependent to a significant degree upon our vendors. As we believe is customary in the industry, we do not have any long-term supply contracts with our vendors. See Risk FactorsRisks Related to Our BusinessWe depend on a relatively small number of manufacturers, suppliers and common carriers, and their inability to supply our requirements could adversely impact our business.

Our distribution center in the Indianapolis, Indiana area supports our Guitar Center retail store operations. Nearly all product flows through the distribution facility, with the exception of special orders, which generally are drop shipments to our stores. We also maintain a smaller distribution facility in Southern California to more efficiently address the movement of products on the West Coast, where appropriate.

We have invested significant time and resources in our inventory control system at the Guitar Center stores. We perform frequent inventory cycle counts, both to measure shrinkage and to update the perpetual inventory on a store-by-store basis. As appropriate, we also stock balance inventory among stores to assure proper distribution of product and to control overall inventory levels.

Direct response

Direct response and other brand online and catalog orders are fulfilled out of our Kansas City, Missouri fulfillment center. Orders, whether taken electronically or by an associate in our customer contact center, are processed by our automated transaction system. We have implemented sophisticated inventory planning systems to increase the level of in-stock products with the goal of maintaining a high initial line item fill rate. The initial line item fill rate reflects the percentage of items ordered by a customer that we are able to supply in the initial shipment to that customer. Split shipments of a single order impose additional shipping, handling and materials costs on us when compared to being able to fulfill an entire order in a single shipment. The technology on our website also permits our customers to monitor their orders online by accessing the UPS and FedEx tracking services.

Music & Arts

Products for our Music & Arts stores generally are processed through a central distribution facility located in Frederick, Maryland. We have a number of local hubs and support centers to enhance product availability during our peak back to school season.

Retail store site selection

We have developed a set of selection criteria to identify prospective store sites for our Guitar Center and Music & Arts stores. In evaluating the suitability of a particular location, we concentrate on the demographics of our target customer as well as traffic patterns and specific site characteristics such as visibility, accessibility, traffic volume, shopping patterns and availability of adequate parking. Our Guitar Center stores generally are located in free-standing locations and high visibility power center shopping centers to maximize their outside exposure and signage, while our Music & Arts stores generally are located in specialized shopping centers to maximize traffic from targeted customers such as students and their parents.

The initial lease terms for our Guitar Center stores are typically 10 years and allow us to renew for three or more additional five-year terms. The initial lease terms for our Music & Arts stores are typically 5 or 10 years and allow us to renew for one additional five-year term. Most of the leases require us to pay property tax, utilities, normal repairs, common area maintenance and insurance expenses.

See Item 6. Selected Financial Data for a summary of Guitar Center and Music & Arts stores opened and closed in the past five years.

We have invested significant resources in information technology systems that provide real-time information for our Guitar Center stores. These systems have been designed to integrate all major aspects of our business, including sales, gross margins, inventory levels, purchase order management, automated replenishment and merchandise planning. Our system capabilities include inter-store transactions, vendor analysis, serial number tracking, inventory analysis and commission sales reporting.

Online sales

We maintain an extensive multi-channel retail transaction processing system, as well as systems supporting e-commerce operations, catalog operations, marketing analysis and internal support information. These systems provide us with marketing, merchandising and operational information and provide contact center and customer service staff with current inventory and customer account information.

Music & Arts

We continue to invest significant resources in the development and implementation of information systems at our Music & Arts stores. These systems are being designed to operate and control significant business processes, including sales, rentals, store operations, inventory levels, purchase order management, special orders and other financial transactions. This business is not susceptible to using off-the-shelf retail solutions because of our large rental business and the presence of off-site sales through affiliates and sales at schools.

Competition

The retail musical instrument industry is highly competitive and fragmented. Our stores compete against other large and small musical instrument retailers, online music retailers, online auctions, direct-to-consumer alternatives and a number of large mass merchants.

Large online companies such as Amazon and eBay increasingly have expanded their offerings of musical instruments and related products. In addition, our retail stores and online operations compete with other direct response musical instrument companies such as American Musical Supply, Sweetwater Sound and Full Compass.

A number of large mass merchants, including Wal-Mart, Best Buy, Target and Costco, sell music products in categories in which we compete.

We are in direct competition with numerous small local and regional musical instrument retailers as well as large national retailers such as Sam Ash Music based in New York, New York. Sam Ash has continued to open and maintain stores in markets in which we are located.

Competition within the musical instrument industry remains dynamic and we cannot predict the scope and extent of national and local competition our retail store and direct response operations will face in the future. In particular, competition within the online portion of our businesses has been increasing and is intense, and we expect that this competition will continue in the future.

We believe that the ability to compete successfully in our markets is determined by several factors, including breadth and quality of product selection, pricing, effective merchandise presentation, customer service, store location and proprietary database marketing programs. See Risks Related to Our Business - Significant existing and new competition in our industry could adversely affect us.

Employees

As of December 31, 2012, we employed 10,188 people, of whom 7,738 were full time employees and 2,450 were part time employees. None of our employees are covered by a collective bargaining agreement. We believe that we enjoy good employee relations.

We own intellectual property including trademarks, service marks and tradenames, some of which are of material importance to our business. These marks and names include Guitar Center, Musicians Friend and Music & Arts. We rely on the trademark, copyright and trade secret laws of the United States and other countries to protect our proprietary rights. Some of our intellectual property is the subject of numerous United States and foreign trademark and service mark registrations. We believe our intellectual property has significant value and is an important factor in our marketing, our stores and our websites.

Seasonality

Our business follows a seasonal pattern, peaking during the holiday selling season in November and December. Sales in the fourth quarter are typically significantly higher in our Guitar Center stores on a per store basis and through the direct response segment than in any other quarter. In addition, band rental season for our Music & Arts stores starts in August and carries through mid-October, but that seasonality does not have a significant impact on our consolidated results.

Item 1A. Risk Factors

Our financial performance is subject to various risks and uncertainties. The risks described below are those which we believe are the material risks we face. Any of the risk factors described below could significantly and adversely affect our business, prospects, sales, revenues, gross profit, cash flows, financial condition, and results of operations.

Risks Related to Our Indebtedness

Our level of indebtedness could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry and prevent us from meeting our obligations under our debt agreements.

We are highly leveraged. As of December 31, 2012, Holdings total consolidated indebtedness was $1.581 billion, which includes Guitar Centers debt of $1.017 billion. This level of indebtedness could have important consequences to our business, including the following:

·it will limit our ability to borrow money or sell stock to fund our working capital, capital expenditures, acquisitions and debt service requirements and other financing needs;

·our interest expense would increase if interest rates in general increase because a substantial portion of our indebtedness, including all of our indebtedness under our senior secured credit facilities, bears interest at floating rates;

·it may limit our flexibility in planning for, or reacting to, changes in our business and future business opportunities;

·we are more highly leveraged than some of our competitors, which may place us at a competitive disadvantage;

·it may make us more vulnerable to a downturn in our business, our industry or the economy in general;

·a substantial portion of our cash flow from operations will be dedicated to the repayment of our and Holdings indebtedness, including indebtedness we may incur in the future, and will not be available for other purposes; and

·there would be a material adverse effect on our business and financial condition if we were unable to service our (or Holdings) indebtedness or obtain additional financing as needed.

Despite our substantial indebtedness, we may still incur significantly more debt, which could further exacerbate the risks described above.

We may be able to incur substantial additional indebtedness in the future. The terms of the agreements governing our senior secured credit facilities and the indentures governing the notes will not fully prohibit us from doing so. Under the indentures governing the notes, in addition to specified permitted indebtedness, we will be able to incur additional indebtedness so long as on a pro forma basis the fixed charge coverage ratio of Guitar Center, Inc. (as defined in the indentures) is at least 2.0 to 1.0. In addition, if we incur any additional indebtedness that ranks equally with the notes, the holders of that debt will be entitled to share ratably in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding up of us. If new debt is added to our and our subsidiaries current debt levels, the related risks that we and they now face could intensify.

We may not be able to generate sufficient cash flows to meet our debt service obligations.

Our (or Holdings) ability to make scheduled payments or to refinance our (or Holdings) debt obligations depends on our financial and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We cannot provide any assurance that we will maintain a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our and Holdings indebtedness. See Managements discussion and analysis of financial condition and results of operationsLiquidity and capital resources.

If our cash flows and capital resources are insufficient to fund our and Holdings debt service obligations, we may be forced to reduce or delay capital expenditures, sell assets or operations, seek additional capital or restructure or refinance our and Holdings indebtedness. We cannot provide any assurance that we would be able to take any of these actions, that these actions would be successful and permit us to meet our and Holdings scheduled debt service obligations or that these actions would be permitted under the terms of our and Holdings existing or future debt agreements. In the absence of such operating results and resources, we could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our and Holdings debt service and other obligations. Our senior secured credit facilities and the indentures that govern the notes will restrict our ability to dispose of assets and use the proceeds from the disposition. We may not be able to consummate those dispositions or to obtain the proceeds which we could realize from them and these proceeds may not be adequate to meet any debt service obligations then due.

If we cannot make scheduled payments on our and Holdings debt, we will be in default and, as a result:

·our and Holdings debt holders could declare all outstanding principal and interest to be due and payable;

·the lenders under our senior secured credit facilities could terminate their commitments to lend us money and foreclose against the assets securing their borrowings; and

·we could be forced into bankruptcy or liquidation.

Restrictive covenants in our credit agreements and the indentures governing the notes will restrict our ability to operate our business and to pursue our business strategies.

The credit agreements governing our senior secured credit facilities and the indentures governing the notes contain, and any future indebtedness we incur may contain, various covenants that limit our ability to, among other things:

·incur or guarantee additional debt;

·incur debt that is junior to senior indebtedness and senior to the senior PIK notes;

·pay dividends or make distributions to our stockholders;

·repurchase or redeem capital stock or subordinated indebtedness;

·make loans, capital expenditures or investments or acquisitions;

·incur restrictions on the ability of certain of our subsidiaries to pay dividends or to make other payments to us;

·merge or consolidate with other companies or transfer all or substantially all of our assets;

·transfer or sell assets, including capital stock of subsidiaries; and

·prepay, redeem or repurchase debt that is junior in right of payment to the notes.

As a result of these covenants, we are limited in the manner in which we conduct our business, and we may be unable to engage in favorable business activities or finance future operations or capital needs. Our senior secured credit facilities also require Holdings to comply with financial covenants, including covenants with respect to, in the case of our term loan facility, a maximum consolidated senior secured net leverage ratio and, in the case of our asset-based revolving credit facility, so long as the excess availability thereunder falls below certain thresholds, a minimum consolidated fixed charge coverage ratio. A breach of any of these covenants could result in a default under our senior secured credit facilities. Upon the occurrence of an event of default under our senior secured credit facilities, the lenders:

·will not be required to lend any additional amounts to us;

·could elect to declare all borrowings outstanding, together with accrued and unpaid interest and fees, to be due and payable, which would result in an event of default under the notes;

·could require us to apply all of our available cash to repay these borrowings; or

·could prevent us from making payments on the senior PIK notes, which could result in an event of default under the notes.

If we were unable to repay those amounts, the lenders under our senior secured credit facilities could proceed against the collateral granted to them to secure that indebtedness. We, the co-borrowers and the guarantors in respect of such facilities pledged a significant portion of our respective assets as collateral under our senior secured credit facilities. If the lenders under our senior secured credit facilities accelerate the repayment of borrowings, we cannot assure you that Holdings or we will have sufficient assets to repay our senior secured credit facilities and our other indebtedness, including the notes, or borrow sufficient funds to refinance such indebtedness. Even if we are able to obtain new financing, it may not be on commercially reasonable terms, or terms that are acceptable to us.

Variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.

Borrowings under our senior secured credit facilities are at variable rates of interest and expose us to interest rate risk. If interest rates increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income would decrease. As of December 31, 2012, we had approximately $621.8 million of variable rate debt (not including approximately $286.8 million of additional undrawn availability under our senior secured asset-based revolving credit facility, after giving effect to $8.6 million of outstanding letters of credit). A 1.0% increase in the interest rate on our floating rate debt would have increased annual interest expense under our senior secured credit facilities by approximately $6.2 million. We do not hedge our interest rate risk by use of derivative instruments and we may in the future be unable to do so.

Our failure to comply with the covenants contained in the credit agreements governing our senior secured credit facilities or our other debt agreements, including as a result of events beyond our control, could result in an event of default which could materially and adversely affect our operating results and our financial condition.

Our credit agreements require Holdings to maintain specified financial ratios, including, in the case of the term loan facility, a maximum ratio of consolidated senior secured net indebtedness to EBITDA and, in the case of the asset-based revolving credit facility, so long as the excess availability thereunder falls below certain thresholds, a minimum consolidated fixed charge coverage ratio. In addition, our credit agreement and the indentures governing the notes require us to comply with various operational and other covenants. If there were an event of default under any of our debt instruments that was not cured or waived, the holders of the defaulted debt could cause all amounts outstanding with respect to the debt to be due and payable immediately, which in turn would result in cross defaults under our other debt instruments. Our assets and cash flow may not be sufficient to fully repay borrowings under our outstanding debt instruments, either upon maturity or if accelerated upon an event of default.

If, when required, we are unable to repay, refinance or restructure our indebtedness under, or amend the covenants contained in, our credit agreements, or if a default otherwise occurs, the lenders under our senior secured credit facilities could elect to terminate their commitments thereunder, cease making further loans, declare all borrowings outstanding, together with accrued interest and other fees, to be immediately due and payable, institute foreclosure proceedings against those assets that secure the borrowings under our senior secured credit facilities and prevent us from making payments on the notes. Any such actions could force us into bankruptcy or liquidation, and we cannot provide any assurance that we could repay our obligations under the notes in such an event.

We may not be able to purchase the notes upon a change of control, which would result in a default under the indentures governing the notes and would adversely affect our business and financial condition.

Upon the incurrence of specific kinds of change of control events, we must offer to purchase the notes. We may not have sufficient funds available to make any required repurchases of the notes, and restrictions under our credit agreement may not allow that repurchase. If we fail to repurchase notes in that circumstance, we will be in default under the indentures governing the notes and, in turn, under our credit agreement. In addition, certain change of control events will constitute an event of default under our credit agreements. A default under our credit agreements would result in an event of default under the indentures governing the notes if the administrative agent or the lenders accelerate our debt under our senior secured credit facilities. Upon the occurrence of a change of control, we could seek to refinance the indebtedness under our senior secured credit facilities and the notes or obtain a waiver from the lenders or the noteholders. We cannot provide any assurance, however, that we would be able to obtain a waiver or refinance our indebtedness on commercially reasonable terms, if at all. Any future debt that we incur may also contain restrictions on repayment of the notes upon a change of control.

Our business is sensitive to consumer spending patterns, which can be affected by prevailing economic conditions. The United States economy generally, and the music products industry in particular, continues to experience an economic slowdown. We cannot predict with accuracy the duration or extent of the slowdown. This downturn in general economic conditions has had an adverse effect on our results of operations over the last several years. We believe that the sensitivity of our operations to general economic conditions and consumer spending patterns has increased as new types of competitors have entered the market and we have expanded our customer base to a greater number of hobbyists and semi-professional musicians and have expanded our footprint to smaller markets. Although we attempt to stay informed of consumer preferences for musical products and accessories typically offered for sale in our stores, any sustained failure on our part to identify and respond to trends would have a material adverse effect on our results of operations, financial condition, business and prospects.

Significant existing and new competition in our industry could adversely affect us.

The retail musical instrument industry is highly competitive and fragmented. Our stores compete against other large and small musical instrument retailers, online music retailers, online auctions, direct-to-consumer alternatives and a number of large mass merchants. These competitors sell many or most of the items we sell and may have greater financial or operational resources than us.

Large online companies such as Amazon and eBay increasingly have expanded their offerings of musical instruments and related products. These companies have significant brand recognition and financial and operational resources dedicated to online direct and marketplace operations. In addition, our retail stores and online operations compete with other direct response musical instrument companies such as American Musical Supply, Sweetwater Sound and Full Compass.

In addition, our online and other direct response operations may require greater efficiency, lower prices, expanded advertising requirements through search engines and other parties and other competitive factors such as free shipping or extended warranties or return periods in order to compete successfully. Each of these factors could have an adverse effect on selling prices and margins in our business and generally constrain our profitability.

A number of large mass merchants, including Wal-Mart, Best Buy, Target and Costco, sell music products in categories in which we compete. These retailers represent a significant source of competition for our retail and direct response operations.

We are in direct competition with numerous small local and regional musical instrument retailers as well as large national retailers such as Sam Ash Music based in New York, New York. Sam Ash has continued to open and maintain stores in markets in which we are located. If we are not able to compete effectively with these competitors, we may fail to achieve market position gains or may lose market share.

As summarized above, competition within the musical instrument industry remains dynamic, and we cannot predict the scope and extent of national and local competition our retail store and direct response operations will face in the future. In particular, competition within the online portion of our businesses has been increasing and is intense, and we expect that this competition will continue in the future. If we are unable to respond effectively to existing and new competition in our industry, our results of operations, financial condition, business and prospects could suffer.

Our failure to develop and implement critical new technology systems for our business could adversely impact our business.

We have developed and implemented new technology systems, including a new e-commerce platform, a multi-channel retail system and a new human resources information system. We also plan to continue investing in technology improvements to our e-commerce platforms and retail systems. If these systems fail to perform as planned, it could lead to the distraction of our management and the need to expend significant additional capital resources. Such a failure could reduce the shopping experience of customers compared to our competitors and impact the data available to our management necessary to run our business efficiently, and as a result could adversely impact our business, results of operations, financial condition and prospects.

We may not be able to grow sales in our existing Guitar Center stores.

Our quarterly comparable stores sales results have fluctuated significantly in the past, and in particular during the current economic slowdown. We do not know whether our new stores or recently opened stores will achieve sales or profitability levels similar to our mature stores.

A shortfall in comparative store sales growth could adversely affect our results of operations and liquidity.

We may be unable to meet our retail store growth strategy, which could adversely affect our results of operations.

Our retail store growth strategy includes increasing sales at existing Guitar Center and Music & Arts locations and opening new locations. The success of any new Guitar Center or Music & Arts stores will depend on many factors, including:

·sufficient management and financial resources to support the new locations;

·vendor support; and

·successful integration of newly-acquired businesses.

A number of these factors are to a significant extent beyond our control. If we are unable to successfully implement our retail growth strategy, or if new stores do not perform to our level of expectations, our results of operations would be adversely affected.

Our business could be adversely affected if we are unable to address unique competitive and merchandising challenges in connection with our plans to open additional Guitar Center and Music & Arts retail stores in new markets.

Part of our retail growth strategy includes plans to open and/or acquire additional Guitar Center and Music & Arts stores in new markets. This expansion into new markets will present unique competitive and merchandising challenges, including:

·significant start-up costs, including promotion and advertising;

·the increasing difficulty in identifying large untapped markets and the consequent expansion into smaller markets that may have different competitive landscapes and customer profiles;

·higher advertising and other administrative costs as a percentage of sales than is experienced in mature markets that are served by multiple stores, particularly in large urban markets where radio and other media costs are high;

·the availability of desirable product lines;

·the potential acquisitions of business lines or geographies in which we have limited or no experience; and

Any of these factors may lead to a shortfall in revenues or an increase in costs with respect to the operation of these stores. If we are not able to operate these stores profitably, or to our expected level of performance, our results of operations could be adversely affected.

We depend on a relatively small number of manufacturers, suppliers and common carriers, and their inability or unwillingness to adequately supply our requirements could adversely impact our business.

Brand recognition is of particular importance in the retail music products business. There are a relatively small number of high quality, recognized brand names in the music products business. We depend on this relatively small number of manufacturers and suppliers for both our existing retail stores and our direct response business. We do not have any long-term contracts with our suppliers and any failure to maintain our relationships with our key brand name vendors would have a material adverse effect on our business.

A number of the manufacturers of the products we sell are limited in size and manufacturing capacity and have significant capital or other constraints. These manufacturers may not be able or willing to meet our increasing requirements for inventory, and there may not be sufficient quantities or the appropriate mix of products available in the future to supply our existing and future stores. These capacity constraints could lead to extended lead times and shortages of desirable products. The risk is especially prevalent in new markets where our vendors have existing agreements with other dealers and may be unwilling or unable for contractual or other reasons to meet our requirements.

The efficient operation of our distribution center for Guitar Center stores is also highly dependent upon compliance by our vendors with precise requirements as to the timing, format and composition of shipments. Additionally, many of our vendors receive products from overseas and depend on an extensive supply chain including common carriers and port access to transport merchandise into the country. Foreign manufacturing is subject to a number of risks, including political and economic disruptions, the imposition of tariffs, quotas and other import or export controls and changes in governmental policies.

We rely on common carriers, including rail and trucking, to transport products from our vendors to our central distribution centers and from these centers to either our stores or customers. A disruption in the services of common carriers due to weather, employee strikes or other unforeseen events could impact our ability to maintain sufficient quantities of inventory in our retail locations or to fulfill orders by direct response customers.

Our hardware and software systems are vital to the efficient operation of our retail stores and direct response business, and damage to these systems could harm our business.

We rely on our computer hardware and software systems for the efficient operation of our retail stores and our direct response business. Our e-commerce systems are responsible for online product sales, customer service and product marketing to our customers and prospective customers. In addition, our information systems provide our management with inventory, sales and cost information that is essential to the operation of our business. Due to our number of stores, geographic diversity and other factors, we would be unable to generate this information in a timely and accurate manner in the event our hardware or software systems were unavailable. These systems are vulnerable to damage or interruption from a number of factors, including earthquake, fire, flood and other natural disasters and power loss, computer systems failure, or security breaches, internet and telecommunications or data network failure.

In addition, a significant information systems failure could reduce the quality or quantity of operating data available to our management. If this information were unavailable for any extended period of time, our management would be unable to efficiently run our business, which would result in a reduction in our net sales and operating results.

We may be adversely impacted if our security measures fail.

Our relationships with our customers may be adversely affected if the security measures that we use to protect their personal information, such as credit card numbers, are ineffective or perceived by consumers to be inadequate. We primarily rely on security and authentication technology that we license from other parties. With this technology, we perform real-time credit card authorization and verification with our banks and we are subject to the customer privacy standards of credit card companies and various consumer protection laws. We cannot predict whether there will be a compromise or breach of the technology we use to protect our customers personal information. If there is a compromise or breach of this nature, there is the potential that parties could seek damages from us, we could lose the confidence of customers or be subject to significant fines from credit card companies or regulatory agencies.

Furthermore, our servers may be vulnerable to computer viruses, physical or electronic break-ins and similar disruptions. We may need to expend significant additional capital and other resources to protect against a security breach or to alleviate problems caused by any breaches.

We need to comply with credit and debit card security regulations.

As a merchant who processes credit and debit card payments from customers, we are required to comply with the Payment Card Industry data security requirements imposed on us for the protection and security of our customers credit and debit card information. If we are unable to remain compliant with these requirements, our business could be harmed because we could incur significant fines from payment card companies or we could be prevented in the future from accepting customer payments by means of a credit or debit card. We also may need to expend significant management and financial resources to become or remain compliant with these requirements, which could divert these resources from other initiatives and adversely impact our financial results.

We rely to a significant extent on foreign manufacturers of various products that we sell, particularly manufacturers located in China. In addition, many of our domestic suppliers purchase a significant portion of their products from foreign sources. This reliance increases the risk that we will not have adequate and timely supplies of various products due to local political, economic, social or environmental conditions (including acts of terrorism, the outbreak of war, or the occurrence of natural disaster), transportation delays (including dock strikes and other work stoppages), restrictive actions by foreign governments, or changes in United States laws and regulations affecting imports or domestic distribution. Reliance on foreign manufacturers also increases our exposure to fluctuations in exchange rates and trade infringement claims and reduces our ability to return product for various reasons.

Additionally, the cost of labor and wage taxes have increased in China, which means we are at risk of higher costs associated with goods manufactured in China. Significant increases in wages or wage taxes paid by contract facilities may increase the cost of goods manufactured in China, which could have a material adverse effect on our profit margins and profitability.

All of our products manufactured overseas and imported into the United States are subject to duties collected by the United States Customs Service. We may be subjected to additional duties, significant monetary penalties, the seizure and forfeiture of the products we are attempting to import or the loss of import privileges if we or our suppliers are found to be in violation of United States laws and regulations applicable to the importation of our products.

Products that we develop or sell may expose us to liability from claims by users of those products for damages, including bodily injury or property damage. This risk is expected to increase as we increase the number and complexity of the proprietary products that we offer. Many of these products are manufactured by small companies located overseas. We currently maintain product liability insurance coverage in amounts that we believe are adequate. However, we may not carry or be able to maintain adequate coverage or obtain additional coverage on acceptable terms in the future. Liability from claims of users of our products could result in damage to our reputation and sales, and our failure to maintain adequate products liability insurance could adversely impact our financial condition.

In addition, we are subject to regulations by a variety of federal, state and international regulatory authorities, including the Consumer Product Safety Commission. We purchase products from hundreds of vendors. Since a majority of our merchandise is manufactured in foreign countries, one or more of our vendors might not adhere to product safety requirements or our quality control standards, and we might not identify the deficiency before merchandise ships to our stores. Any issues of product safety, including those manufactured in foreign countries, could cause us to recall some of those products. If the recall affects our proprietary products, or if our vendors are unable or unwilling to recall products failing to meet our quality standards, we may be required to recall those products at a substantial cost to us. These recalls may adversely impact our reputation and brands, potentially leading to increases in customer litigation against us. Further, to the extent we are unable to replace any recalled products, we may have to reduce our merchandise offerings, resulting in a decrease in sales, especially if the unavailability occurs near or during a seasonal period.

Moreover, changes in product safety or other consumer protection laws could lead to increased costs to us for merchandise, or additional labor costs associated with readying merchandise for sale. Long lead times on merchandise ordering cycles increase the difficulty for us to plan and prepare for potential changes to applicable laws. The Consumer Product Safety Improvement Act of 2008 imposes significant requirements on manufacturing, importing, testing and labeling requirements for our products. In addition, various federal and state regulations directly impact our products, such as the Lacey Act, the Formaldehyde Air Toxic Control Measure issued by the California Air Resources Board and the California Transparency in Supply Chains Act. In the event that we are unable to timely comply with regulatory changes, significant fines or penalties could result, and could adversely affect our reputation, results of operations, cash flow and financial condition.

We have outsourced some of our information technology functions, which makes us more dependent upon third parties.

We place significant reliance on a third party provider for the outsourcing of a variety of our information technology functions. These functions are generally performed at an offshore location, with our oversight. As a result, we are relying on third parties to ensure that these functional needs are sufficiently met. This reliance subjects us to risks arising from the loss of control over these processes, changes in pricing that may affect our operating results and potentially the termination of provision of these services by our supplier. If our service providers fail to perform, we may have difficulty arranging for an alternate supplier or rebuilding our own internal resources, and we could incur significant costs, all of which may have a significant adverse effect on our business.

We may outsource other administrative functions in the future, which would further increase our reliance on third parties. Further, the use of offshore service providers may expose us to risks related to local political, economic, social or environmental conditions (including acts of terrorism, the outbreak of war, or the occurrence of natural disaster), restrictive actions by foreign governments or changes in United States laws and regulations.

Changes in regulations or enforcement may adversely impact our business

We are subject to federal, state and local regulations with respect to our operations in the United States. The enactment or enforcement of legislative and regulatory initiatives such as wage or workforce issues, collective bargaining matters, environmental regulation, price and promotion regulation, trade regulations and others could adversely impact our business.

Any changes in the way that online business is regulated or taxed could impose additional costs on us and adversely affects our financial results.

The adoption or modification of laws or regulations, or revised interpretations of existing laws, relating to the online commerce industry could adversely affect the manner in which we currently conduct our online and catalog business and the results of operations of those businesses. For example, laws and enforcement practices related to the taxation of catalog, telephone and online commercial activity, including the collection of sales tax on direct response sales, remain in flux. In recent years, states increasingly have focused on the taxation of out of state retailers, such as Amazon, in an effort to reduce their budget shortfalls. As the result of aggressive taxation positions, we have had to terminate our direct response advertisers that are located in states where new laws have passed. In addition, we at times are subject to information requests and claims by states relating to state sales and use tax matters.

In addition, the growth and development of the market for online commerce may lead to more stringent consumer protection laws, both in the United States and abroad, that may impose additional burdens on us. Laws and regulations directly applicable to communications or commerce over the internet are becoming more prevalent. The law of the internet, however, remains largely unsettled, even in areas where there has been some legislative action. It may take years to determine whether and how existing laws such as those governing intellectual property, consumer privacy, sales-based and other taxation of e-commerce transactions and the like are interpreted and enforced.

Further, our direct response business established physical presence in California in 2011, and as a result is required to collect and remit sales tax on behalf of California customers. This change resulted in decreased sales in California, as we are at a competitive disadvantage against e-commerce retailers who do not collect sales tax from California customers. We cannot provide any assurance that our sales and marketing strategies will result in regaining market share in California.

Any adverse change in any of these laws or in the enforcement, interpretation or scope of existing laws could have a material adverse effect on our results of operations, financial condition or prospects.

Our operations are subject to health care regulations. There are a number of existing and proposed legislative and regulatory initiatives relating to health care that could adversely impact our business. In particular, we expect that the Patient Protection and Affordable Care Act will increase our annual health care costs, with the most significant increases coming in 2014.

In addition, we self-insure our workers compensation claims up to $500,000 per claim and medical insurance claims of up to $400,000 per claim. Excess amounts are covered by stop-loss insurance coverage, subject to an aggregate annual deductible of $100,000 for medical insurance claims. As a result, increases in health care claims or coverage costs may adversely impact our financial condition.

We face risks created by litigation and governmental proceedings.

Historically, we have been involved in a variety of lawsuits. Current and future litigation that we may face may result in substantial costs and expenses and significantly divert the attention of our management regardless of the outcome, and an unfavorable resolution could have a material adverse effect on our business, financial condition and results of operations.

From time to time, the litigation we have faced has included purported class action lawsuits based on our credit card practices, payroll practices and other matters, and we may face other purported class action lawsuits in the future. The costs of these lawsuits could be significant, particularly if a plaintiff were to succeed in obtaining certification of a class nationwide or in a large region in which we operate.

We are the largest musical instrument retailer in the United States based on revenue. Our significant size within our industry may increase the scrutiny that we receive regarding antitrust or other matters. In the past, we have been subject to an investigation by the Federal Trade Commission regarding our pricing practices. While this investigation was resolved without any action by the Federal Trade Commission, private litigants used some of the information from a related investigation of a major trade association to bring class action claims presently pending against us. See Item 3. Legal Proceedings for more detail on these claims. These actions, as well as other current and future litigation or governmental proceedings, could lead to increased costs or interruptions of our normal business operations and may adversely affect our financial condition and results of operations.

Our Music & Arts business is dependent on state and local funding of music programs in primary and secondary schools, and decreases in funding would adversely affect our Music & Arts business.

Our Music & Arts business derives the majority of its revenue from sales or services to music students enrolled in primary and secondary schools. Any decrease in the state and local funding of such music programs could have a material adverse effect on our Music & Arts business and its results of operations.

Our inability to address the special risks associated with acquisitions could adversely impact our business.

We believe that our expansion may be accelerated by the acquisition of existing music product retailers, including in foreign markets. We regularly investigate acquisition opportunities complementary to our Guitar Center, direct response and Music & Arts businesses. Accordingly, in the ordinary course of business, we consider, evaluate and enter into negotiations related to potential acquisition opportunities. We may pay for these acquisitions in cash or securities or a combination of both. Attractive acquisition targets may not be available at reasonable prices or we may not be successful in any such transaction. Acquisitions involve a number of special risks, including:

·diversion of our managements attention;

·integration of acquired businesses with our business; and

·unanticipated legal liabilities and other circumstances or events.

Our failure to identify complementary acquisitions, our failure to obtain favorable pricing on those acquisitions or the occurrence of any special risks involved in acquisitions could have a material adverse effect on our ability to achieve our growth strategy, and our results of operations could be materially affected as a result.

Increased fuel costs have increased both the cost of the products that we purchase as well as the transportation of these products between our distribution or fulfillment centers and our stores or consumers. In addition, fluctuations in gas prices have disrupted consumer spending by leaving consumers with comparatively less money to spend for retail and entertainment. This disruption may lead to reduced sales. Either of these trends could have a material adverse effect on our results of operations, financial condition, business and prospects.

Claims of infringement of intellectual property rights of third parties or inadequately acquiring or protecting our intellectual property could harm our ability to compete or grow.

Parties have filed, and in the future may file, claims against us alleging that we have infringed third party intellectual property rights. If we are held liable for infringement, we could be required to pay damages or obtain licenses or to cease making or selling certain products. Licenses may not be available at all, or may not be available on commercially reasonable terms, and the cost to defend these claims, whether or not meritorious, could be significant and could divert the attention of management.

We could also have our intellectual property infringed. We rely on the trademark, copyright and trade secret laws of the United States and other countries to protect our proprietary rights, but there can be no guarantee that these will adequately protect all of our rights, or that any of our intellectual property rights will not be challenged or held invalid or unenforceable in a dispute with third parties. If we are unable to enforce our intellectual property rights against third parties, our business, financial condition and results of operations may be adversely affected.

We depend on key personnel, including our senior management, who are important to the success of our business.

Our success depends to a significant extent on the services of members of our senior management. The loss of the services of one or more of these individuals or other key personnel and changes in the composition of our senior management team could have a material adverse effect on our business, results of operations, liquidity and financial position.

Our Chief Executive Officer resigned in November 2012 and in January 2013 we appointed an interim Chief Executive Officer who is experienced in the specialty retail industry. If we are unable to successfully integrate a new Chief Executive Officer, we could lose the services of other key personnel, which could adversely impact our business, results of operations, liquidity and financial position.

From time to time, we release projections and similar guidance regarding our future performance that represent managements estimates as of the date of release. These projections, which are forward-looking statements, are prepared by our management and are qualified by, and subject to, the assumptions and the other information contained or referred to in the release. Our projections are not prepared with a view toward compliance with published guidelines of the American Institute of Certified Public Accountants, and neither our registered public accountants nor any other independent expert or outside party compiles or examines the projections and, accordingly, no such person expresses any opinion or any other form of assurance with respect thereto.

Projections are based upon a number of assumptions and estimates that, while presented with numerical specificity, are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and are based upon specific assumptions with respect to future business decisions, some of which will change. We generally state possible outcomes as high and low ranges which are intended to provide a sensitivity analysis as variables are changed but are not intended to represent that actual results could not fall outside of the suggested ranges. The principal reason that we release this data is to provide a basis for our management to discuss our business outlook with analysts and investors. We do not accept any responsibility for any projections or reports published by any such persons.

Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions of the projections furnished by us will not materialize or will vary significantly from actual results. Accordingly, our projections are only an estimate of what management believes is realizable as of the date of release. Actual results will vary from the projections and the variations may be material. Investors should also recognize that the reliability of any forecasted financial data diminishes the farther in the future that the data is projected.

Any failure to successfully implement our operating strategy or the occurrence of any of the events or circumstances set forth in this annual report could result in the actual operating results being different from the projections, and such differences may be adverse and material.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

The following summarizes the general location, use and approximate size of our principal properties as of March 15, 2013:

On September 11, 2009, a putative class action was filed by an individual consumer named David Giambusso in the United States District Court for the Southern District of California. The complaint alleged that Guitar Center and other defendants, including a trade association and a large musical instrument manufacturer, exchanged sensitive information and strategies for implementing minimum advertised pricing, attempted to restrict retail price competition and monopolize at trade association-organized meetings, all in violation of Sections 1 and 2 of the Sherman Antitrust Act and Californias Unfair Competition Law. Subsequently, numerous additional lawsuits were filed in several federal courts (and one state court) attempting to represent comparable classes of plaintiffs with parallel allegations. Some of these lawsuits have expanded the group of defendants to include other manufacturers and others have alleged additional legal theories under state laws.

In December 2009 and January 2010, the Judicial Panel on Multidistrict Litigation issued several orders which had the effect of consolidating all pending actions in federal court under the caption In Re Musical Instruments and Equipment Antitrust Litigation, Case No. MDL-2121 (MDL 2121), except one filed in Tennessee. A consolidated amended complaint in MDL 2121 was filed on July 16, 2010, in the United States District Court for the Southern District of California. On August 20, 2010, defendants filed a motion to dismiss the consolidated amended complaint. The hearing was held on November 1, 2010. The court rendered its opinion on August 19, 2011, granting the motion to dismiss with leave to amend. Plaintiffs filed a first amended consolidated class action complaint on September 22, 2011. On December 28, 2011, the Magistrate Judge issued an order limiting the scope of discovery to non-public meetings at NAMM conventions. This ruling was affirmed by the District Court on February 7, 2012. On February 24, 2012, plaintiffs filed a second amended complaint. On March 26, 2012, defendants filed a motion to dismiss the second amended complaint. The motion was heard by the court on May 21, 2012. On August 20, 2012, the court dismissed, with prejudice, plaintiffs Sherman Act claim for failure to plead an antitrust conspiracy. On September 9, 2012, defendants filed a motion to alter or amend the judgment, requesting that the court amend the judgment to include the dismissal of plaintiffs state-law claims. This motion was denied on jurisdictional grounds. Plaintiffs filed an appeal before the Ninth Circuit Court of Appeals which is currently pending. With regard to the Tennessee action, we had previously filed a motion to dismiss on September 3, 2010. On February 22, 2011, the plaintiff filed an amended complaint, for which we filed an additional motion to dismiss on March 24, 2011. The parties in the Tennessee action have agreed to cooperate with regard to a scheduling order, accordingly there is no hearing date set for the motion to dismiss. The plaintiffs in the consolidated actions are seeking an injunction against further behavior that has been alleged, as well as monetary damages, restitution and treble damages in unspecified amounts. The plaintiffs in the Tennessee action are seeking no more than $5.0 million in compensatory damages. We are not currently able to estimate a probable outcome or range of loss in this matter.

On August 31, 2011, a putative class action was filed by a former employee in San Francisco Superior Court in an action entitled Carson Pellanda vs. Guitar Center, Inc. The complaint alleges that Guitar Center allegedly violated California wage and hour laws, including failure to provide required meal periods, rest breaks, unpaid work time, and failure to provide accurate itemized wage statements. On October 4, 2011, a first amended complaint was filed, adding new allegations, including wrongful termination. Guitar Center has retained defense counsel. The first amended complaint seeks injunctive relief as well as monetary damages in unspecified amounts. Mediation was held on May 17, 2012. The matter did not settle. On September 6, 2012, a Second Amended Complaint was filed, incorporating the allegations of a parallel wage and hour matter, Gomez vs. Guitar Center Stores, Inc., which was subsequently dismissed. Discovery continues. We are not currently able to estimate a probable outcome or range of loss in this matter.

On May 24, 2011, a putative class action was filed in Los Angeles Superior Court in an action entitled Jason George vs. Guitar Center, Inc. and Guitar Center Stores, Inc. The complaint alleges that Guitar Center violated the California Song-Beverly Credit Card Act by requesting that its customers provide personal identification information in connection with the use of their credit cards. The complaint seeks monetary damages including statutory civil penalties in amounts of up to $1,000 per violation. This matter was subsequently consolidated with Justin Hupalo vs. Guitar Center, a putative class action alleging violations of the Song-Beverly Credit Card Act, filed on October 27, 2011. Discovery continues. In December 2012, a motion for summary judgment was filed on behalf of Guitar Center. This motion is currently pending. We are not currently able to estimate a probable outcome or range of loss in this matter.

In addition to the matters described above, we are involved in various claims and legal actions in the normal course of business. We expect to defend all unresolved actions vigorously. We cannot assure you that we will be able to achieve a favorable settlement of these lawsuits or obtain a favorable resolution if they are not settled. However, it is managements opinion that, after consultation with counsel and a review of the facts, a material loss with respect to our financial position, results of operations and cash flows is not probable from such currently pending normal course of business litigation matters.

Holdings common stock is privately held and there is no established public trading market for its stock. Guitar Centers common stock is owned by Holdings and there is no established trading market for such stock.

During the year ended December 31, 2012, Holdings did not issue any shares of common stock.

Holders

As of December 31, 2012, there were 19 holders of Holdings common stock. Holdings owns all of the common stock of Guitar Center.

Dividends

Holdings did not declare or pay any cash dividends on its common stock in 2012 or 2011and does not anticipate paying any cash dividends in the near future. Our senior secured credit facilities and the indentures governing the notes impose restrictions on our and Holdings ability to pay dividends or make distributions to our and its stockholders.

Item 6. Selected Financial Data

The following table sets forth our selected historical consolidated financial data for the periods and at the dates indicated. We derived the selected historical financial data as of December 31, 2012 and 2011 and for the years ended December 31, 2012, 2011 and 2010 from our audited historical consolidated financial statements included in this annual report. We derived the selected historical financial data as of December 31, 2010, 2009 and 2008 and for the years ended December 31, 2009 and 2008 from our audited historical consolidated financial statements not included in this annual report. Our historical results included below and elsewhere in this annual report are not necessarily indicative of our future performance.

The following selected financial data should be read in conjunction with Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements and accompanying notes thereto included elsewhere in this annual report. Amounts in tables may not add due to rounding.

Our calculation of comparable retail store sales includes sales from Guitar Center stores that have been open for 14 months and does not include sales originated on our Guitar Center website. We do not exclude relocated, remodeled or retrofitted stores from the calculation of comparable store sales. All references in this annual report to comparable store sales results are based on this calculation methodology.

(1)Capital expenditures include additions to our property, plant, and equipment and do not include any expenditures to add to our rental instruments inventory.

(2)The following table discloses Holdings EBITDA (earnings before interest, taxes, depreciation and amortization) and Adjusted EBITDA (EBITDA adjusted for other items described below), which are non-GAAP financial measures. Generally, a non-GAAP financial measure is a numerical measure of a companys performance, financial position or cash flows that either excludes or includes amounts that are not normally included or excluded in the most directly comparable measure calculated and presented in accordance with GAAP. EBITDA and Adjusted EBITDA do not represent and should not be considered as alternatives to net income or cash flow from operations, as determined under GAAP.

We present Adjusted EBITDA because it is the primary measure used by our chief operating decision makers to evaluate our consolidated performance, as well as the performance of each of our segments. Adjusted EBITDA is also a measure which is used in calculating financial ratios in several material debt covenants in our asset-based credit facility and our term loan. Adjusted EBITDA is defined as EBITDA adjusted to exclude non-cash items and certain other adjustments to consolidated net income permitted under our debt agreements. We believe the inclusion of supplementary adjustments to EBITDA applied in presenting Adjusted EBITDA is appropriate to provide additional information about certain non-cash items, items that we do not expect to continue at the same level and other items.

The material covenants in our debt agreements are discussed in Managements Discussion and Analysis of Financial Condition and Results of Operations  Liquidity and Capital Resources.

EBITDA and Adjusted EBITDA have limitations as analytical tools, and you should not consider them either in isolation or as substitutes for analyzing our results as reported under GAAP. Some of these limitations are:

·EBITDA and Adjusted EBITDA do not reflect our interest expense, or the cash requirements necessary to service interest or principal payments, on our debt;

·EBITDA and Adjusted EBITDA do not reflect our tax expense or the cash requirements to pay our taxes;

·EBITDA and Adjusted EBITDA do not reflect historical cash expenditures or future requirements for capital expenditures or contractual commitments;

·although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and EBITDA and Adjusted EBITDA do not reflect any cash requirements for such replacements; and

Non-cash rent expense represents the difference between cash rent paid and GAAP rent expense. Under GAAP, the aggregate of minimum rental payments is recorded as rent expense on a straight-line basis over the lease term. Cash and other allowances received for tenant improvements are amortized over the lease term and reduce GAAP rent expense. Our adjustment eliminates the portion of rent expense resulting from the difference between straight-line rent expense and cash rent paid, and the amortization of tenant improvement allowances.

(b)Non-recurring charges in 2011 consist of the loss recognized on the sale of our corporate aircraft.

Non-recurring charges in 2008 consist of consulting and other expenses related to organizational changes after our acquisition by affiliates of Bain Capital.

(c)Other adjustments include severance payments, accrued bonuses under our long term management incentive plan, gains and losses on disposal of assets, management fees paid to Bain Capital, cash received for tenant improvement allowances and certain other items permitted under our debt agreements.

Other adjustments in 2012 include restructuring costs of $2.1 million related to the re-alignment of management and support functions and the relocation of our direct response operations.

Other adjustments in 2011 include restructuring costs of $13.0 million related to the re-alignment of management and support functions and the relocation of our direct response operations.

Other adjustments in 2009 include a $3.9 million tax audit settlement and $1.3 million of consulting and other transition expenses related to outsourcing certain information technology functions.

Severance payments totaled $1.0 million in 2012, $1.3 million in 2011, $4.7 million in 2010, $0.8 million in 2009 and $3.4 million in 2008.

(3)Comparable store sales are presented for Guitar Center retail stores only and does not include Guitar Center online sales or Music & Arts sales.

Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with Selected Financial Data and our consolidated financial statements and related notes included elsewhere in this annual report.

The following discussion, as well as other portions of this annual report, contains forward-looking statements that reflect our plans, estimates and beliefs. Any statements (including, but not limited to, statements to the effect that we or our management anticipate, plan, estimate, expect, believe, intend, and other similar expressions) that are not statements of historical fact should be considered forward-looking statements and should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this annual report. Specific examples of forward-looking statements include, but are not limited to, statements regarding our forecasts of financial performance, capital expenditures, working capital requirements and forecasts of effective tax rates. All forward-looking statements are subject to risks and uncertainties that may cause our actual results to differ materially from our expectations. Factors that could cause or contribute to such differences include, but are not limited to, those discussed below and elsewhere in this annual report, and particularly in Risk Factors.

Amounts shown in the tables below are generally rounded. Therefore, discrepancies in the tables between totals and the sum of the amounts listed may occur.

Overview

We are the leading retailer of music products in the United States based on revenue. We operate three reportable business segments: Guitar Center, direct response and Music & Arts. Our Guitar Center segment offers guitars, amplifiers, percussion instruments, keyboards and pro audio and recording equipment through our retail stores and online, along with repair services and rehearsal and/or lesson space in a limited number of stores. Our direct response segment brands offer catalog and online sales of a broad selection of music products under several brand names, including Musicians Friend, Music123 and Woodwind & Brasswind. Our Music & Arts segment offers band and orchestra instruments for rental and sale, music lessons and a limited selection of products of the type offered by our Guitar Center segment.

Since 2012, our GTRC Services, Inc. subsidiary has operated shared support services for all our brands, including distribution and fulfillment centers, contact centers and technology services. These operations were previously managed separately by our retail store and direct response subsidiaries. We believe that centralizing the management of these shared operations will improve our flexibility to manage these resources efficiently and execute strategic initiatives. Substantially all of the costs of these shared service operations are allocated among our segments based on estimated usage, as determined primarily based on sales, cost of goods sold or call volume at each business.

Certain costs related to corporate office facilities were previously incurred directly by our Guitar Center and direct response segments. Upon implementing GTRC Services, Inc., our corporate office facility is shared and the related costs are not allocated to our business segments. Segment results for 2011 and 2010 in this management discussion and analysis have been adjusted to reflect this change.

History

Guitar Center was founded in 1964 in Hollywood, California.

In May 1999, we acquired Musicians Friend, Inc., an Oregon-based direct response musical instrument retailer. Musicians Friend is a leading direct response retailer of music products in the United States, through both its catalogs and e-commerce websites.

In April 2001, we acquired American Music Group, Ltd. and its related companies, a musical instrument retailer specializing in the rental and sale of band instruments and accessories serving the student and family market. In April 2005, we acquired Music & Arts Center, Inc., a Maryland-based music products retailer which primarily serves the beginning musician and emphasizes rentals, music lessons and band and orchestra instrument sales. Subsequent to the Music & Arts acquisition, our American Music and Music & Arts segments were combined into a new division of our retail store subsidiary that operates under the Music & Arts name.

In February 2007, we acquired substantially all of the assets of Dennis Bamber, Inc., d/b/a The Woodwind & The Brasswind and Music123, an Indiana-based direct response retailer of music products. We refer to these businesses as Woodwind & Brasswind and Music123.

Acquisition by Bain Capital, LLC

On October 9, 2007, Guitar Center merged with an entity substantially owned by affiliates of Bain Capital. In connection with the merger, Holdings acquired all of the outstanding capital stock of Guitar Center for aggregate cash consideration of approximately $1.9 billion. Holdings, which is substantially owned by affiliates of Bain Capital, owns 100% of the stock of Guitar Center.

Our indebtedness may limit our flexibility in planning for, or reacting to, changes in our business and future business opportunities since a substantial portion of our cash flow from operations will be dedicated to the repayment of debt, and this may place us at a competitive disadvantage to some of our competitors that may be less leveraged. Our leverage may make us more vulnerable to a downturn in our business, industry or the economy in general. See Risk FactorsOur level of indebtedness could adversely affect our ability to raise capital to fund our operations, limit our ability to react to changes in the economy or our industry and prevent us from fulfilling our obligations under our debt agreements.

We believe that a number of key revenue and cost factors are significant to understanding the operation of our business. Our business also is influenced by general economic and retail industry conditions, as well as trends in the music products industry.

Revenue and cost factors

Guitar Center store growth. A significant factor affecting the operating results of our Guitar Center business is our rate of store growth. We grew quickly during the period between January 2005 and December 2007, with 78 of our Guitar Center stores being opened or acquired during that period. During the period from January 2008 to December 2010, we did not open any new stores in order to focus on development of our store management and sales force and to allow existing new stores to reach mature sales levels. Having largely achieved these objectives, we opened 10 new stores in 2011 and 16 new stores in 2012. We plan to open 15 new stores in 2013 and between 15 and 20 new stores per year in the upcoming years. The high level of capital expenditures and related working capital requirements associated with opening new stores, coupled with the lower sales at less mature stores may have a negative impact on our short-term operating results.

Store maturity. New stores generally take a number of years to reach what we consider mature sales levels. We generally expect our primary format and secondary format stores to reach mature sales levels in approximately four years and three years, respectively.

New store costs. The average cost of initial capital improvements for new stores opened in 2011 and 2012 was approximately $1.6 million for a primary market store, $1.3 million for a secondary market store and $1.0 million for a tertiary market store. We often receive tenant improvement allowances from our landlords to help defray these costs. We expect to incur similar costs for stores opening in 2013. In addition, initial gross inventory requirements for new stores are generally between $1.1 million and $1.6 million for a primary market store, between $0.8 million to $1.1 million for a secondary market store and $0.6 million for a tertiary market store. We also incur costs to hire and train store personnel and to link our new stores to our distribution and support systems. Outside of opening new stores, capital expenditure requirements to maintain our Guitar Center store business historically have been relatively low.

Proprietary products. Our Guitar Center stores operating profit is affected by the mix of products we sell. In particular, our average gross selling margin for our proprietary products is significantly higher than for branded products in corresponding categories. Part of our business strategy is to further develop our proprietary products to take advantage of this greater profitability. We also arrange with certain vendors to obtain exclusive products not available to other retailers in order to offer our customers a unique product selection on which we can earn a higher selling margin. Our proprietary products sales have grown from approximately 7% of our net sales in 2006 to approximately 12% of our net sales in 2012. We endeavor to strike a balance between expanding our proprietary products and maintaining good relationships with our vendors who offer competing brand name products.

Online marketing. Our direct response business is primarily focused on online sales of our products, although our catalogs remain an important marketing tool. In addition, our online channels for Guitar Center and Music & Arts are becoming increasingly important sales channels. We must act quickly to respond to online marketing trends, and we incur significant costs to upgrade our infrastructure to respond to these trends. During 2009 and 2010, we invested significant capital in developing a sophisticated internal search and comparison shopping engine to improve user functionality and search capability. During 2010 and 2011, we developed enhanced capabilities for our Guitar Center online channel to allow our customers more flexibility to purchase products that can be picked up in-store, delivered from retail store locations or shipped directly to the customer. We continue to invest in upgrades and enhancements to our e-commerce websites.

Music & Arts efficiencies. In recent years, we have focused on improving the operational efficiencies of and reducing working capital requirements of our Music & Arts business. Among other things, we have reduced selling, general and administrative expenses for this business and made operational changes to achieve better returns on our rental inventory. We plan to grow this business through opening new stores and acquiring businesses within this fragmented market and integrating them with our Music & Arts business.

Economic and demographic factors

Discretionary spending. We believe that our Guitar Center customers comprise a mix of professional and aspiring professional musicians, novice musicians and hobbyists. We believe that professional and aspiring professional musicians view their purchases as a career necessity and these sales are less sensitive to general retail economic trends. However, a significant portion of sales to other customer groups in our Guitar Center and other businesses depends on discretionary spending by consumers. We expect that overall consumer confidence and discretionary spending will continue to have a significant impact on our sales.

Market saturation. From 1997 to 2006, our revenue grew significantly through the addition of new Guitar Center stores and through acquisitions. As a result, there are fewer remaining unsaturated large population centers in the United States where we could open new primary format stores. We believe new store growth is likely to include a greater proportion of secondary and tertiary format stores, which typically deliver lower operating margins than our primary format stores.

Restructuring and exit activities

We initiated a restructuring plan in 2011 to re-align certain management and support functions across the organization. As part of the restructuring plan, we relocated the management operations of our direct response business from Medford, Oregon to Southern California in the fourth quarter of 2011. We believe that having the operations of our Guitar Center and direct response businesses at a single location will improve our ability to execute strategic initiatives.

Costs related to this restructuring activity totaled $2.1 million in 2012 and $13.0 million in 2011. Cumulative costs for the restructuring activities totaled $15.1 million and the restructuring activities were substantially complete in the first half of 2012.

Costs incurred in connection with this restructuring activity included employee termination costs, which consisted of severance payments and retention bonuses for personnel in Medford and at our corporate office, employee relocation assistance, incremental travel expenses, information technology integration and other similar costs.

See Note 3 in the combined notes to consolidated financial statements included in this annual report for a summary of restructuring costs by type and a summary of accruals, payments and adjustments of accrued employee termination costs.

Results of Operations

The following tables present our consolidated net income or loss, as a percentage of sales, for the periods indicated:

Net sales from our Guitar Center segment increased 4.3% to $1.596 billion in 2012 from $1.530 billion in 2011. Non-comparable retail stores open for less than 14 months added $50.8 million in incremental revenue. Comparable retail store sales increased 0.9%, or $12.6 million, and sales from our Guitar Center website decreased 1.2%, or $1.1 million. The increase in comparable store sales was primarily due to higher sales conversion rates, which is our measure of the number of sales transactions relative to the number of customers visiting our stores. We improved conversion rates at our stores by reducing checkout times and by implementing workforce planning tools that increased the customer service experience due to the availability of staff. We believe the decrease in online sales was primarily due to fewer promotional discounting tactics, which resulted in lower online sales volume with improved gross profit margin during 2012.

Net sales from our direct response segment decreased 5.5% to $353.3 million from $374.0 million in 2011. The decrease was primarily due to a 4.6% decrease in order count and a 0.6% decrease in average order value. Our direct response segment continues to be affected by e-commerce competition, with fewer new customers in 2012 and a lower rate of converting website visits into sales transactions. We believe that these factors, along with reduced spending on marketing and advertising, drove the decrease in order count in 2012. The decrease in average order value was primarily due to fewer items sold per order. We expect competition to continue to affect this segments net sales and gross profit for the foreseeable future.

Net sales from our Music & Arts segment increased 6.3% to $189.8 million from $178.4 million in 2011. The sales increase was primarily due to a 3.1% increase in sales to school districts from our successful efforts to win more high-volume bid contracts and a 2.2% increase in retail store sales.

Gross profit

Consolidated gross profit increased 1.3% to $643.4 million in 2012 from $635.1 million in 2011. Gross profit margin decreased to 30.1% from 30.5% in 2011.

Gross profit margin for our Guitar Center segment was 28.8% in 2012 compared to 29.3% in 2011. The decrease was primarily due to lower selling margin of 0.3% resulting from competitive pressure on pricing. We adjusted selling prices, particularly in the fourth quarter, in the form of merchandise markdowns, promotional discounts and in-store discounts to ensure our Lowest Price Guarantee policy.

Gross profit margin for our direct response segment was 27.6% in 2012 and 2011. A decrease of 0.3% in selling margin was partially offset by a decrease of 0.2% in shrink expense. The decrease in selling margin was primarily due to price discounting in response to competitive pressures. The decrease in shrink expense was due to changes to internal procedures that have improved merchandise recovery rates on customer returns.

Gross profit margin for our Music & Arts segment was 45.3% in 2012 compared to 46.7% in 2011. The decrease was primarily due to lower selling margin of 1.6% resulting from a shift in sales channel mix with increased sales to school districts at lower margins than rental and retail sales.

Selling, general and administrative expenses

Consolidated selling, general and administrative expenses of Holdings decreased 5.4% to $547.7 million from $579.2 million in 2011. As a percentage of net sales, consolidated selling, general and administrative expenses of Holdings were 25.6% in 2012 compared to 27.8% in 2011. In addition to changes in selling, general and administrative expenses at our business segments, which are discussed below, the consolidated decrease includes a $5.3 million loss on the sale of our corporate aircraft in 2011 that did not re-occur in 2012 and a $2.1 million decrease in corporate restructuring costs.

Consolidated selling, general and administrative expenses of Guitar Center for 2011 do not include expenses totaling $0.3 million related to the amendments and extension of Holdings long-term debt that were not allocated to Guitar Center.

Selling, general and administrative expenses for our Guitar Center segment were 22.4% of segment net sales in 2012 compared to 23.3% in 2011. The decrease was primarily due to lower depreciation and amortization expense of 0.6%, lower compensation expense of 0.3% and lower group medical insurance expense of 0.2%. Depreciation and amortization expense decreased primarily due to lower amortization expense on the segments customer relationship intangible asset, which uses an accelerated method based on expected customer attrition rates. Compensation expense decreased primarily due to lower bonus expense in 2012. Group medical expense decreased due to lower claims costs and modifications to our self-insured plan that became effective at the beginning of the third quarter of 2012.

Selling, general and administrative expenses for our direct response segment were 26.9% of segment net sales in 2012 compared to 31.2% in 2011. The decrease was primarily due to lower depreciation and amortization expense of 2.0%, lower restructuring costs of 1.9% and lower group medical insurance expense of 0.5%. Depreciation and amortization expense decreased due to impairment of the segments customer relationship intangible assets in the fourth quarter of 2011. Restructuring costs decreased as a result of our reorganization plan being substantially completed during the first half of 2012. Group medical expense decreased due to lower claims costs and modifications to our self-insured plan that became effective at the beginning of the third quarter of 2012.

Selling, general and administrative expenses for Music & Arts were 36.8% of segment net sales in 2012 compared to 38.3% in 2011. The decrease was primarily due to lower compensation expense of 1.0% resulting from leveraging on higher net sales.

Operating income (loss)Holdings

Consolidated operating income (loss) for Holdings increased to $95.7 million operating income in 2012 from $97.1 million operating loss in 2011. Consolidated operating income as a percentage of net sales was 4.5% in 2012, compared to an operating loss of 4.7% in 2011.

In addition to the changes in gross margin and selling, general and administrative expenses, Holdings operating income or loss was affected by impairment charges totaling $153 million in 2011 at our direct response segment. The impairment charges in 2011 consisted of $107.0 million related to goodwill, $32.5 million related to trade name intangible assets and $13.5 million related to customer relationship intangible assets. These impairment charges resulted from increased competition and declining sales at our direct response segment in 2011.

The future growth of the direct response business is dependent upon the success of our initiatives to optimize the new Musicians Friend web platform, the success of our marketing and customer acquisition strategies and the effective emergence from the restructuring activities of 2011 and the first half of 2012. The operating results of direct response in 2012 and 2011 indicated to us that it may take longer than we expected to realize the benefits of these initiatives and neutralize the increased competitive pressures in the e-commerce sector. If these efforts are not successful, we may incur additional impairment charges in the future.

The following table presents the carrying amount of our direct response intangible assets, including goodwill, as of December 31, 2012 and 2011 after recognizing impairment charges (in thousands):

Consolidated operating income (loss) for Guitar Center increased to $95.7 million operating income in 2012 from $96.8 million operating loss in 2011. Consolidated operating income as a percentage of net sales was 4.5% in 2012, compared to an operating loss of 4.6% in 2011.

In addition to the changes in gross profit and selling, general and administrative expenses, Guitar Centers operating loss was affected by impairment charges totaling $153 million in 2011 at our direct response segment. The impairment charges resulted from reduced projections about the segments future financial performance, as described in the preceding discussion of Holdings operating income and loss.

Interest expense- Holdings and Guitar Center

Net interest expense for Holdings increased 2.7% to $165.3 million from $161.0 million in 2011.

Net interest expense for Guitar Center increased 5.3% to $85.4 million from $81.1 million in 2011.

The increase in interest expense at Holdings and Guitar Center was primarily due to increases of $3.0 million related to the term loan, $0.5 million related to the Guitar Center senior notes and $0.3 million related to the asset-based revolving credit facility.

Interest expense on our floating-rate term loan increased in part due to an increase in the pricing margin over LIBOR resulting from the amendment and extension of the term loan facility in March 2011 and in part due to an increase in the LIBOR index rate. Interest expense on the senior notes increased due to the issuance of $19.9 million of new senior notes in October 2012, bearing interest at a rate of 11.5% per annum and maturing in 2017. The issuance of new senior notes was the result of our election to require the holders of the senior PIK notes to reinvest one-half of the interest payment due in October 2012 in the senior notes. Interest expense on our asset-based revolving credit facility increased $0.3 million due to greater use of the facility in 2012 to meet working capital needs.

Income tax expense (benefit)Holdings

Income tax expense for Holdings was $2.5 million in 2012, compared to $21.2 million income tax benefit in 2011. The effective tax rate for 2012 was -3.6%, compared to 8.2% in 2011.

Income tax expense recognized in 2012 was primarily related to state income taxes currently payable. The negative effective tax rate in 2012 was due to state income tax expense and a valuation allowance applied to deferred tax assets that we do not expect to realize in the foreseeable future. We determined that the available objective evidence indicated that it is more likely than not that the tax benefits of our operating losses will not be fully realized. Accordingly, we began applying a valuation allowance to deferred tax assets in the fourth quarter of 2011 and we did not recognize income tax benefits for our consolidated loss before income taxes.

Income tax benefits recognized in 2011 were primarily related to deferred income taxes from amortization and impairment charges on our intangible assets other than goodwill. The effective rate in 2011 was lower than the expected amount based on statutory income tax rates primarily due to goodwill impairment charges of $107 million that are not recognized for income tax purposes and a valuation allowance of $32.2 million applied to deferred tax assets.

Income tax expense (benefit)Guitar Center

Income tax expense for Guitar Center was $6.9 million in 2012, compared to $24.2 million income tax benefit in 2011. The effective tax rate in 2012 was 67.0% compared to 13.6% in 2011.

The increase in income tax expense was primarily the result of higher pretax net income.

The effective tax rate in 2012 was higher than the expected amount based on statutory income tax rates primarily due to adjustments to effective state rates applied to deferred tax assets and liabilities.

The effective rate in 2011 was lower than the expected amount based on statutory income tax rates primarily due to goodwill impairment charges of $107 million that are not recognized for income tax purposes.

Net sales from our Guitar Center segment increased 5.9% to $1.530 billion in 2011 from $1.445 billion in 2010. We opened ten new stores during 2011 which contributed $22.3 million in sales. Comparable retail store sales increased 3.7%, or $50.4 million, and sales from our Guitar Center website increased 15.5%, or $12.3 million, compared to 2010. The increase in comparable store sales and online sales were primarily due to a 2.8% increase in the number of transactions and a 1.8% increase in average order size. We believe the increase in transaction count can be attributed to successful television advertising and improvements in our multi-channel selling capabilities. The increase in average order size is primarily the result of tiered coupon promotions encouraging customers to make larger purchases.

Net sales from our direct response segment decreased 4.2% to $374.0 million in 2011 from $390.4 million in 2010. The decrease was primarily experienced in the fourth quarter, with lower sales during the holiday selling season. We believe the reduced sales were partially due to challenges encountered in rolling out a new web platform for our Musicians Friend website and the business interruption that occurred due to the relocation of our e-commerce corporate headquarters to Southern California. Our direct response segment also faced increasing competition as established online retailers add musical instruments to their product offerings. We expect this competition to affect this segments net sales and gross profit for the foreseeable future.

Net sales from our Music & Arts segment increased 1.6% to $178.4 million in 2011 from $175.7 million in 2010.

Gross profit

Consolidated gross profit increased 4.8% to $635.1 million in 2011 from $605.9 million in 2010. Gross profit margin increased to 30.5% in 2011 from 30.1% in 2010.

Gross profit margin for our Guitar Center segment was 29.3% in 2011 compared to 28.8% in 2010. The increase was primarily due to lower occupancy costs of 0.5%. The decrease in occupancy costs was primarily due to lower depreciation and amortization expense, reflecting the slower pace of capital expenditures for refurbishments and relocations of our existing stores.

Gross profit margin for our direct response segment was 27.6% in 2011 compared to 28.1% in 2010. The decrease was primarily due to higher freight costs of 0.3% and lower selling margin of 0.2%. Freight expense increased primarily due to higher fuel surcharges and increased outbound shipments to customers due to the segments shipping policy initiative, which offers free shipping on more price points.

Gross profit margin for our Music & Arts segment was 46.7% in 2011 compared to 45.6% in 2010. The increase was primarily due to higher selling margin of 0.7% and lower shrinkage expense of 0.2%. The improvement in selling margin was driven by product mix and pricing.

Selling, general and administrative expenses

Consolidated selling, general and administrative expenses of Holdings increased 6.1% to $579.2 million in 2011 from $546.1 million in 2010. The consolidated increase in selling, general and administrative expenses includes restructuring charges of $13.0 million and a loss of $5.2 million on the sale of our corporate aircraft that were not incurred in the prior year. Corporate restructuring charges of $3.6 million, the loss on sale of our corporate aircraft of $5.2 million and fees related to the amendments of our debt facilities and related SEC registration expenses totaling $2.0 million were not allocated to our business segments. Consolidated selling, general and administrative expenses were 27.8% of net sales in 2011 compared to 27.2% in 2010.

Consolidated selling, general and administrative expenses of Guitar Center in 2011 do not include expenses totaling $0.3 million related to the amendments and extension of Holdings long-term debt that were not allocated to Guitar Center.

Selling, general and administrative expenses for our Guitar Center segment were 23.3% of segment net sales in 2011 compared to 23.8% in 2010. The decrease was primarily due to lower compensation costs of 0.4% and lower depreciation and amortization expense of 0.3%, partially offset by higher group medical costs of 0.2%. Compensation expense decreased due to leveraging on higher net sales and a reduction of our long-term incentive plan bonus accruals based on 2011 consolidated operating results. Depreciation and amortization expense decreased primarily due to lower amortization expense on our customer relationship intangible asset, which uses an accelerated method based on expected customer attrition rates. Group medical expense was higher due to increased claims costs on our self-insured medical plan.

Selling, general and administrative expenses for our direct response segment were 31.2% of segment net sales in 2011 compared to 27.1% in 2010. The increase was primarily due to restructuring costs of 2.1% and higher depreciation and amortization expense of 1.9%. Restructuring charges were not incurred in 2010 and were primarily comprised of employee termination benefits, consulting and other costs related to the relocation of our direct response headquarters operations. Depreciation expense increased due to upgrades to our e-commerce platforms and accelerated depreciation on our Medford office facility that was classified as held for sale as of December 31, 2011.

Selling, general and administrative expenses for Music & Arts were 38.3% of segment net sales in 2011 compared to 39.1% in 2010. The decrease was primarily due to lower compensation costs of 0.4% and lower advertising costs of 0.3%. Compensation expense decreased due to lower bonus expense. Advertising expense decreased due to the reduced use of advertising tactics that do not meet our required return on investment.

Operating income (loss)Holdings

Consolidated operating income (loss) for Holdings decreased to $97.1 million operating loss in 2011 from $59.7 million operating income in 2010. Consolidated operating loss as a percentage of net sales was 4.7% in 2011, compared to operating income of 3.0% in 2010.

In addition to the changes in gross margin and selling, general and administrative expenses, Holdings operating loss was affected by impairment charges totaling $153 million in 2011 at our direct response segment. The impairment charges in 2011 consisted of $107.0 million related to goodwill, $32.5 million related to trade name intangible assets and $13.5 million related to customer relationship intangible assets. These impairment charges were the result of increased competition and declining sales at our direct response segment in 2011.

Given the uncertainty as to whether or when our direct response business would regain customers that it had lost or failed to attract during the final implementation of a new web platform in 2011, the impact of commencing sales tax collection in California, and the disruption caused by the relocation of our direct response headquarters operations in 2011, we reduced our revenue and cash flow projections for the direct response business at the end of 2011. As a result of reduced revenue and cash flow projections for the direct response business in 2011, the estimated fair values of the segments intangible assets were lower than their carrying amounts. Similarly, the estimated fair value of the direct response reporting unit in 2011 was lower than its carrying amount. We recorded impairment charges for the amount by which the carrying amounts of our trade name and customer relationship intangible assets exceeded their estimated fair values. We recorded an impairment charge for the entire carrying amount of goodwill at the direct response reporting unit.

Operating income (loss)Guitar Center

Consolidated operating income (loss) for Guitar Center decreased to $96.8 million operating loss in 2011 from $59.7 million operating income in 2010. Consolidated operating loss as a percentage of net sales was 4.6% in 2011, compared to operating income of 3.0% in 2010.

In addition to the changes in gross margin and selling, general and administrative expenses, Guitar Centers operating loss was affected by impairment charges totaling $153 million in 2011 at our direct response segment resulting from reduced projections about the segments future financial performance, as described in the preceding discussion of Holdings operating income and loss.

Net interest expense for Holdings increased 10.9% to $161.0 million from $145.2 million in 2010. The increase was primarily due to higher interest expense of $9.4 million on our term loan and $5.6 million on our senior PIK notes. Interest expense on the term loan increased due to the amendment and extension of the term loan facility completed during the first quarter of 2011, which increased the pricing margin over LIBOR from 350 basis points to 525 basis points on the extended principal balance. Interest expense on the senior PIK notes increased due to the addition of accrued interest to the outstanding principal, as permitted under the debt agreement.

Interest expenseGuitar Center

Net interest expense for Guitar Center increased 14.5% to $81.1 million from $70.8 million in 2010. The increase was primarily due to higher interest expense of $9.4 million on our term loan. Interest expense on the term loan increased due to the amendment and extension of the term loan facility completed during the first quarter of 2011, which increased the pricing margin over LIBOR from 350 basis points to 525 basis points on the extended principal balance.

Income tax benefitHoldings

Income tax benefit for Holdings was $21.2 million in 2011, compared to $29.1 million in 2010. The effective tax rate for 2011 was 8.2%, compared to 34.1% in 2010.

The effective rate was lower in 2011 primarily due to goodwill impairment charges of $107 million that are not recognized for income tax purposes and a valuation allowance of $32.2 million applied to deferred tax assets that we do not expect to realize in the foreseeable future. Based on our recent history of reporting net losses for financial reporting and income tax purposes in recent years, we determined that the available objective evidence indicated that it is more likely than not that the tax benefits of these operating losses will not be realized.

Income tax benefitGuitar Center

Income tax benefit for Guitar Center was $24.2 million in 2011, compared to $2.3 million in 2010. The effective tax rate 2011 was 13.6% compared to 20.3% in 2010.

The effective rate was lower in 2011 primarily due to goodwill impairment charges of $107 million that are not recognized for income tax purposes.

Liquidity and capital resources

Our principal sources of cash are cash generated from our retail and e-commerce businesses and available borrowing capacity under our asset-based revolving credit facility. Our principal uses of cash typically include capital expenditures, the financing of working capital and payments on our indebtedness.

We expect to make a principal payment of $129.8 million in April 2013 related to paid-in-kind interest on Holdings senior PIK notes. See Debt  Notes for more information about this payment and significant terms of Holdings senior PIK notes. We expect to fund this payment with cash available from operations and, to the extent necessary, by drawing on the asset-based revolving credit facility.

In 2012, cash provided by operating activities totaled $34.9 million for Holdings and $94.6 million for Guitar Center.

Our asset-based revolving credit facility provides senior secured financing of up to $373 million, subject to a borrowing base. As of December 31, 2012, the borrowing base was $295.4 million, which supported $8.6 million of outstanding letters of credit and $286.8 million of undrawn availability.

Our business follows a seasonal pattern, peaking during the holiday selling season in November and December. Cash generated from our Guitar Center stores and through our e-commerce businesses are typically significantly higher in the fourth quarter than in any other quarter. Cash requirements to finance working capital are typically highest during the third quarter as we build inventory for fourth quarter holiday season sales for our Guitar Center and direct response brands. Seasonality for our Music & Arts business centers on band rental season, which starts in August and carries through mid-October, but that seasonality does not have a significant impact on our liquidity.

Holdings business activities consist solely of debt and equity financing related to its ownership of Guitar Center, and consequently Holdings does not generate cash flows other than amounts distributed to it by Guitar Center. Holdings is dependent on distributions received from Guitar Center to meet its debt service obligations on the senior PIK notes. The senior PIK notes are not guaranteed by any of Holdings subsidiaries.

We believe that the asset-based revolving credit facility, our cash on hand and funds generated from operations will be adequate to fund debt service requirements, capital expenditures and working capital requirements for the next 12 months. Over the longer term, we expect that operating cash flows from our existing businesses will continue to be adequate to fund capital expenditures and working capital requirements. We plan to expand our retail store presence and increase our investments in e-commerce, with the goal of increasing the operating cash flows from our existing businesses to fund debt service requirements. Our ability to continue to fund these items and continue to reduce debt may be affected by general economic, financial, competitive, legislative and regulatory factors and the cost of litigation claims, among other factors.

Given that our primary source of liquidity is cash flows generated from operating activities, our liquidity has been and will continue to be affected by general economic conditions in the United States, particularly with respect to discretionary consumer spending in the retail sector and our ability to generate sales revenue. If we do not have sufficient cash flows from operating activities, we may be required to limit our retail store growth strategy. Additionally, we may be unable to meet our debt service requirements, which would have a material adverse impact on our business and operations. We cannot be assured that any replacement borrowing or equity financing could be successfully completed on terms similar to our current financing agreements, or at all.

Cash flows

Operating activities

Holdings net cash provided by operating activities was $34.9 million in 2012. Cash provided by operating income was partially offset by an increase in working capital. Significant uses of cash during 2012 included a net increase of $17.0 million in merchandise inventories, primarily for new Guitar Center stores opened during the year. Cash paid for interest in 2012 was $141.3 million.

Holdings net cash used in operating activities was $24.9 million in 2011. Cash provided by operating income was exceeded by an increase in working capital. Significant uses of cash for working capital and other activities included a $46.1 million net increase in merchandise inventories to support new store growth, expand product assortments and increase proprietary inventory levels. Cash payments for interest in 2011 were $157.5 million, which included interest payments of $79.6 million on the senior PIK notes that were not required in 2010.

Holdings and Guitar Centers net cash provided by operating activities was $143.4 million in 2010. Significant sources of cash from changes in working capital in 2010 included a decrease in prepaid expenses and other current assets of $16.2 million, primarily from refunds received on amended 2007 income tax returns, an increase in accrued expenses and other current liabilities of $16.8 million related to accrued interest on the senior PIK note and a net decrease in inventory of $11.4 million. Cash payments for interest totaled $69.0 million in 2010.

Guitar Centers net cash provided by operating activities was $94.6 million in 2012 and $55.0 million in 2011. The difference between Holdings and Guitar Center operating cash flow in 2012 and 2011 represents payment of interest on Holdings long-term debt.

Holdings and Guitar Centers net cash used in investing activities was $64.6 million in 2012, compared to $53.5 million in 2011.

Capital expenditures in 2012 included $20.0 million related to new Guitar Center stores and $10.5 million related to the relocation and remodeling of existing Guitar Center and Music & Arts stores. In addition, capital expenditures included $11.5 million related to information technology development and new purchases and $13.3 million related to the maintenance and update of existing information technology. Net proceeds from sales of property and equipment during 2012 included $2.8 million received on the sale of our Medford office building.

Capital expenditures in 2011 included approximately $27.6 million in information technology development and purchases, $16.0 million related to new Guitar Center stores and $4.3 million to remodel or refurbish existing Guitar Center and Music & Arts stores. Proceeds from the disposal of property and equipment totaled $4.0 million in 2011 and included net proceeds of $3.2 million on the sale of our corporate aircraft.

Capital expenditures in 2010 included approximately $33.3 million in information technology development and purchases and $5.1 million to remodel or refurbish existing Guitar Center stores.

Financing activities

Holdings cash used in financing activities was $1.5 million in 2012 and $9.3 million in 2011. Cash used in financing activities in 2012 was primarily related to fees paid to our lenders in connection with obtaining additional extended commitments under our asset-based revolving credit facility. Cash used in financing activities in 2011 was primarily related to the payment of fees to our lenders in connection with an amendment of the terms and extension of maturity dates for our long-term debt, including the asset-based revolving credit facility. In 2010, we made a prepayment of principal of $20.1 million on our term loan facility relating to excess 2009 cash flow. Similar prepayments were not required in 2012 or 2011 for excess cash flow.

Guitar Centers cash used in financing activities was $61.1 million in 2012, compared to $89.2 million in 2011. In 2012, Guitar Center funded interest payments of $79.6 million on Holdings senior PIK notes and received $19.9 million in new funding from the issuance of senior notes. Under an election available under the senior PIK notes, we elected to require the holders of the senior PIK notes to reinvest one-half of the interest payment due in October 2012 in new Guitar Center senior notes. In 2011, Guitar Center made distributions of $81.0 million to Holdings, primarily to fund interest payments on the senior PIK notes. Cash paid for financing fees in 2012 and 2011 was related to an amendment of terms and extension of maturity dates for Guitar Centers long-term debt. In 2010, Guitar Center made a prepayment of principal of $20.1 million on the term loan facility relating to excess 2009 cash flow. Similar prepayments were not required in 2012 or 2011 for excess cash flow.

We opened 16 new Guitar Center stores during 2012, comprised of five primary format locations, four secondary format locations and seven tertiary format locations, and we plan to open 15 new Guitar Center stores in 2013. We also plan to continue opening new stores at a rate of 15 to 20 stores per year in the upcoming years, in a combination of store formats. New stores generally take a number of years to reach what we consider mature sales levels, generally four years for our primary format stores and three years for our secondary format stores.

Our average cost of capital improvements for new Guitar Center stores opened in 2011 and 2012 was approximately $1.6 million for primary market store, $1.3 million for a secondary market store and $1.0 million for a tertiary market store. These costs generally consist of leasehold improvements, fixtures and equipment and do not include tenant improvement allowances that we may receive from our landlords to help defray these costs. We do not expect our costs for capital improvements to increase significantly for stores opened in 2013. Additionally, our new primary stores generally require between $1.1 million and $1.6 million of gross inventory, secondary stores require between $0.8 million to $1.1 million of gross inventory and tertiary market stores require approximately $0.6 million of gross inventory upon store opening.

For 2013, we expect our total capital expenditures will be between $65 million and $70 million. We expect this amount will include $20 to $25 million of information technology expenditures, approximately $20 million of new store expenditures and approximately $15 million to remodel, relocate and refurbish existing stores. Planned remodeling and refurbishing expenditures include costs for adding GC Studios lesson and rehearsal space to existing stores.

Our outstanding long-term debt as of December 31, 2012 consisted of a senior secured term loan, senior notes of Guitar Center and senior PIK notes of Holdings. The aggregate outstanding principal balance on this debt as of December 31, 2012 was $1.581 billion.

We expect interest payments on the term loan, senior notes and senior PIK notes will be between $140 million and $150 million per year in the years 2013 through 2016 and approximately $130 million in total for the years 2017 and 2018.

We also have an asset-based revolving credit facility with a maximum borrowing amount of $373 million, subject to a borrowing base which is calculated monthly based on specified percentages of eligible inventory, credit card receivables and trade receivables. As of December 31, 2012, the borrowing base was $295.4 million, which supported $8.6 million of outstanding letters of credit and $286.8 million of undrawn availability. Our daily average borrowings on the asset-based revolving credit facility during 2012 were $9.7 million.

We expect our borrowings on the asset-based revolving credit facility to increase in 2013 and for the next several years, primarily due to the principal prepayment of $129.8 million Holdings senior PIK notes that we expect to make in April 2013. This principal payment will require a significant portion of our operating cash. As a result, we expect our usage and interest payments on the asset-based facility to increase accordingly.

The majority of scheduled maturities of our long-term debt occur in 2017 and 2018, with total maturities of $1.418 billion in those years. Scheduled maturities and principal payments for the years 2013 through 2016 total $163.2 million, which includes the $129.8 million principal payment on Holdings senior PIK notes that we expect to make in April 2013. Our long-term debt agreements include restrictive covenants that could require early payment in the event of default.

As of December 31, 2012, we were in compliance with our debt covenants. Under the term loan credit agreement, we were required to have a consolidated secured net leverage ratio as of December 31, 2012 that does not exceed 3.5x. As of December 31, 2012, our consolidated secured net leverage ratio was 2.8x.

A summary of the material terms of our term loan credit facility, asset-based revolving credit facility, senior notes and senior PIK notes are described below.

Senior Secured Term Loan Credit Facility

On October 9, 2007, we entered into a senior secured term loan credit facility. The term loan facility was amended as of March 2, 2011.

The term loan facility matures on April 9, 2017 for term loans that were extended pursuant to the amendment in March 2011, and October 9, 2014 for term loans that were not extended at that time. As of December 31, 2012, the term loan facility consisted of $613.8 million of extended term loans and $7.9 million of non-extended term loans.

The borrower under the term loan facility is Guitar Center. All obligations under the term loan facility are unconditionally guaranteed by our primary subsidiaries. The collateral for borrowings under the term loan facility consists of a first-priority security interest in all of the capital stock in subsidiaries held by Holdings, Guitar Center and the guarantors, substantially all plant, material owned real property and equipment of Guitar Center and the guarantors and substantially all other personal property of Guitar Center and the guarantors other than the asset-based facility collateral, including patents, copyrights, trademarks, other general intangibles and related proceeds. The collateral also consists of a second-priority security interest in our asset-based facility collateral, which includes all accounts receivable arising from the sale of inventory and other goods and services, inventory, cash, deposit accounts and related proceeds.

At our option, loans under the term loan facility may be maintained from time to time as prime rate loans or LIBO rate loans. Prime rate loans bear interest at the applicable margin (as defined below) in excess of (1) the highest of the variable annual rate of interest determined by JPMorgan Chase Bank, N.A. as its prime rate, (2) 1/2 of 1.00% per annum in excess of the federal funds rate or (3) a LIBO Rate applicable to an interest period of one month (or, if higher, and only in the case of extended term loans, three months) on such day plus 1.00% per annum. LIBO rate loans bear interest at the applicable margin in excess of a LIBO Rate. The applicable margin means a percentage per annum equal to, in the case of any (1) non-extended term loan that is a prime rate loan, 2.50%, (2) non-extended term loan that is a LIBO rate loan, 3.50%, (3) extended term loan that is a prime rate loan, 4.25% and (4) extended term loan that is a LIBO rate loan, 5.25%.

The term loan facility provides for incremental term loan facilities in an aggregate principal amount of $50.0 million plus the amount available such that the consolidated secured net leverage ratio is less than or equal to 2.75:1.00 on a pro forma basis after giving effect to the incremental indebtedness, provided that each incremental term loan facility shall be no less than $10.0 million (unless such lesser amount represents all remaining availability under the incremental term loan facilities) and no default or event of default shall exist or arise from the incremental facility.

The term loan facility requires us to comply with customary affirmative and negative covenants. It also requires us to comply with financial covenants, including covenants with respect to our consolidated secured net leverage ratio. The consolidated secured net leverage ratio covenant becomes more restrictive over time.

Asset-Based Revolving Credit Facility

On October 9, 2007, Guitar Center, as lead borrower, entered into a senior secured asset-based loan facility. The asset-based facility was amended on March 2, 2011.

The asset-based facility matures on February 9, 2016 for the portion that was extended pursuant to the amendment in March 2011, and October 9, 2013 for the portion that was not extended. We obtained additional commitments on our asset-based revolving credit facility of $15 million in September 2011 and $55 million in March 2012 to substitute the commitments of other participating lenders that did not extend their commitments in March 2011.

The terms of the new commitments, other than the extended maturity date, are the same as existing terms under the facility. As of December 31, 2012, the asset-based facility consisted of a $323 million extended revolving credit facility and a $50 million non-extended revolving credit facility, including a $25.0 million swing line sub-facility and a $100.0 million letter of credit sub-facility. We had no borrowings outstanding on the asset-based facility as of December 31, 2012.

Borrowers under the asset-based facility include Guitar Center, Guitar Center Stores, Inc. and Musicians Friend, Inc. All obligations under the asset-based facility are unconditionally guaranteed by our primary subsidiaries. The collateral for borrowings under the asset-based facility consists of a first-priority security interest in the asset-based collateral and a second-priority security interest in the term loan collateral, as discussed above in Senior Secured Term Loan Credit Facility.

At our option, loans under the asset-based facility may be maintained from time to time as prime rate loans or LIBO rate loans. Prime rate loans bear interest at the applicable margin (as defined below) in excess of the highest of (1) the variable annual rate of interest determined by JPMorgan Chase Bank, N.A. as its prime rate, (2) 1/2 of 1.00% per annum in excess of the federal funds rate and (3) a LIBO Rate applicable to an interest period of one month on such day plus 1.00% per annum. LIBO rate loans bear interest at the applicable margin in excess of a LIBO Rate which is adjusted for maximum reserves. The applicable margin is defined to mean a percentage per annum based on our average daily excess availability. If our average daily excess availability is greater than $250.0 million, the applicable margin is equal to, in the case of any (1) non-extended asset-based loan that is a prime rate loan, 0.00%, (2) non-extended asset-based loan that is a LIBO rate loan, 1.25%, (3) extended asset-based loan that is a prime rate loan, 1.75% and (4) extended asset-based loan that is a LIBO rate loan, 2.75%. If our average daily excess availability is greater than $125.0 million but less than or equal to $250.0 million, the applicable margin is equal to, in the case of any (1) non-extended asset-based loan that is a prime rate loan, 0.25%, (2) non-extended asset-based loan that is a LIBO rate loan, 1.50%, (3) extended asset-based loan that is a prime rate loan, 2.00% and (4) extended asset-based loan that is a LIBO rate loan, 3.00%. If our average daily excess availability is less than or equal to $125.0 million, the applicable margin is equal to, in the case of any (1) non-extended asset-based loan that is a prime rate loan, 0.50%, (2) non-extended asset-based loan that is a LIBO rate loan, 1.75%, (3) extended asset-based loan that is a prime rate loan, 2.25% and (4) extended asset-based loan that is a LIBO rate loan, 3.25%.

The borrowers pay the administrative agent, for the account of the non-extended asset-based facility lenders, an aggregate fee at a rate per annum equal to 0.25% per annum of the average daily balance of the unused commitments under the non-extended portion of the facility quarterly in arrears. This fee is 0.50% per annum of the average daily balance of the unused commitments under the extended portion of the facility for the extended asset-based facility lenders.

Revolving loans may be borrowed, repaid and re-borrowed at any time to fund our working capital needs and for other general corporate purposes. The asset-based facility provides for incremental revolving credit facilities to increase the aggregate of the then outstanding extended commitments in an aggregate principal amount of $75.0 million, plus an amount equal to the aggregate amount of the terminated non-extended commitments.

The asset-based facility requires us to comply with customary affirmative and negative and financial covenants. It also requires us to comply with financial covenants which require us to maintain our consolidated fixed charge coverage ratio as of the last day of each quarter of at least 1.00 to 1.00.

Notes

On August 7, 2008, Guitar Center issued $375 million of the senior notes and Holdings issued $401.8 million of the senior PIK notes. The terms of the senior notes and senior PIK notes, including the maturity dates, were amended on March 2, 2011. As of December 31, 2012, we and Holdings, respectively, had outstanding $394.9 million in aggregate principal amount of senior notes and $564.7 million in aggregate principal amount of senior PIK notes.

The senior notes mature on October 15, 2017 and the senior PIK notes mature on April 15, 2018. Interest on the senior notes accrues at a rate of 11.50% per annum, payable semi-annually in cash in arrears on April 15 and October 15 of each year. Interest on the senior PIK notes accrues at a rate of 14.09% per annum, payable semi-annually in arrears on April 15 and October 15 of each year. Until and through October 15, 2010, Holdings paid interest on the senior PIK notes by increasing the principal amount of such notes for the entire amount of the interest payment.

Under the amended terms of the senior PIK notes, we were permitted to require the holders of the senior PIK notes to reinvest 50% of the four semi-annual interest payments due between April 2011 and October 2012 in newly issued senior notes, provided a secured net leverage ratio of 8.5x is maintained. We made such an election only for the interest payment due in October 2012, resulting in the issuance of $19.9 million in additional Guitar Center senior notes. We did not make the reinvestment election for interest payments due in 2011 or in April 2012.

The senior notes are guaranteed on an unsecured senior basis by each of our subsidiaries that is a guarantor under our senior secured credit facilities described above. The senior PIK notes are not guaranteed by Guitar Center or any of its subsidiaries.

The indentures governing the notes contain covenants limiting, among other things, our ability and the ability of restricted subsidiaries to: (1) incur or guarantee additional indebtedness, or issue disqualified stock or preferred stock; (2) pay dividends or make distributions to our stockholders; (3) repurchase or redeem capital stock or subordinated indebtedness; (4) make investments or acquisitions; (5) incur restrictions on the ability of certain of our subsidiaries to pay dividends or to make other payments to us; (6) enter into transactions with affiliates; (7) create liens; (8) merge or consolidate with other companies or transfer all or substantially all of our assets; (9) transfer or sell assets, including capital stock of subsidiaries; and (10) prepay, redeem or repurchase debt that is junior in right of payment to the notes.

Guitar Center may redeem some or all of the senior notes at any time on or after October 15, 2013 at 100% of the principal amount of senior notes to be redeemed, together with accrued and unpaid interest, if any, to the date of redemption.

Holdings may redeem some or all of the senior PIK notes at any time on or after October 15, 2013 at the redemption prices (expressed as percentages of principal amount of senior PIK notes to be redeemed) set forth below, together with accrued and unpaid interest, if any, to the date of redemption:

Period

Percentage

October 15, 2013 - October 14, 2014

101.7613

%

October 15, 2014 and thereafter

100.000

%

Guitar Center and Holdings, respectively, also may redeem some or all of the respective notes at any time prior to October 15, 2013, in each case, at a price equal to 100% of the principal amount of the notes to be redeemed plus a make whole premium and accrued and unpaid interest, if any, to the date of redemption.

If Guitar Center or Holdings, as applicable, experiences a change of control, we or Holdings, as applicable, will be required to make an offer to purchase the senior notes or senior PIK notes, as applicable, at a price equal to 101% of their principal amount, together with accrued and unpaid interest, if any, to the date of purchase. In addition, certain asset dispositions are triggering events which may require us or Holdings to use the proceeds from those asset dispositions to make an offer to purchase the senior notes or senior PIK notes, as applicable, at 100% of their principal amount, together with accrued and unpaid interest, if any, to the date of purchase.

If the senior PIK notes would otherwise constitute applicable high yield discount obligations within the meaning of Section 163 (i)(1) of the Internal Revenue Code at the end of the first accrual period ending after the fifth anniversary of November 28, 2007, Holdings will be required to redeem for cash a portion of each senior PIK note then outstanding equal to the mandatory principal redemption amount. The redemption price for the portion of each senior PIK note redeemed will be 100% of the principal amount of such portion plus any accrued interest thereon on the date of redemption. The mandatory principal redemption amount means the portion of a senior PIK note required to be redeemed to prevent such note from being treated as an applicable high yield discount obligation within the meaning of Section 163(i)(1) of the Internal Revenue Code. We expect to make a principal payment in April 2013 equal to the mandatory principal redemption amount of $129.8 million. We expect to have sufficient liquidity to fund the April 2013 principal payment on the senior PIK notes.

The indentures governing the notes contain customary events of default, including, but not limited to, cross-defaults among other debt agreements. An event of default, if not cured, could cause cross-default causing substantially all of our indebtedness to become due.

Certain dividend restrictions

The guarantors under the term loan facility, the asset-based facility and the senior notes are generally not restricted in their ability to dividend or otherwise distribute funds to Guitar Center except for restrictions imposed under applicable state corporate law. However, Guitar Center is limited in its ability to pay dividends or otherwise make distributions to Holdings under the term loan facility, the asset-based facility and the indenture governing the senior notes. Specifically, the term loan facility and the asset-based facility each prohibits Guitar Center from making any distributions to Holdings except for limited purposes, including, but not limited to: (i) the payment of interest on the senior PIK notes by Holdings so long as no payment or bankruptcy event of default exists; (ii) general corporate, overhead and similar expenses of Holdings incurred in the ordinary course of business, (iii) the payment of taxes by Holdings as the parent of a consolidated group that includes Holdings, Guitar Center and the guarantors, (iv) the partial redemption or prepayment of the senior PIK notes by Holdings to the extent necessary to make an applicable high yield discount obligation (AHYDO) catch-up payment thereon and (v) advisory fees of Holdings not to exceed the amounts payable in respect thereof under the advisory agreement with Bain Capital as in effect on October 9, 2007 so long as certain events of default do not exist. Notwithstanding the foregoing, so long as no event of default existed or exists, Guitar Center may make distributions to Holdings in an aggregate amount not to exceed $25 million after March 2, 2011.

The senior notes indenture provides that Guitar Center can generally pay dividends and make other distributions to Holdings in an amount not to exceed (a) 50% of Guitar Centers consolidated net income for the period beginning March 2, 2011 and ending as of the end of the last quarter before the proposed payment, plus (b) 100% of the net cash proceeds received by Guitar Center from the issuance and sale of capital stock, plus (c) 100% of cash contributions to Guitar Centers capital, plus (d) to the extent not included in consolidated net income, 100% of the amount received in cash from the sale or other disposition of certain investments, provided that certain conditions are satisfied, including that Guitar Center would, at the time of the proposed payment and after giving pro forma effect thereto, have been permitted to incur at least $1.00 of additional indebtedness pursuant to the fixed charge coverage ratio test set forth in the indenture. Similar provisions regarding dividends and other distributions payable by Holdings are included in the senior PIK notes indenture.

Notwithstanding the foregoing, the senior notes indenture provides that Guitar Center can generally pay dividends and make other distributions to Holdings to, among other things, fund (A) interest payments on the senior PIK notes, (B) any mandatory redemption of a portion of the senior PIK notes pursuant to the senior PIK notes indenture, (C) an offer to purchase upon a change of control or asset sale to the extent required by the terms of the senior PIK notes indenture, (D) tax payments, (E) general corporate overhead and operating expenses and (F) fees of Holdings under the advisory agreement with Bain Capital.

The following table reflects our significant contractual cash obligations as of December 31, 2012. Some of the figures included in this table are based on managements estimates and assumptions about these obligations, including their duration, the possibility of renewal, anticipated actions by third parties and other factors. Because these estimates and assumptions are necessarily subjective, the obligations we will actually pay in future periods may vary from those reflected in the table.

Payments due by period(dollars in millions)

Total

2013

2014  2015

2016  2017

2018 and thereafter

Guitar Center:

Long-term debt obligations(1)

$

1,016.7

$

5.9

$

20.8

$

990.0

$



Interest on long-term debt(2)

366.4

80.1

158.8

127.5



Operating lease obligations(3)

356.4

76.8

130.9

80.5

68.2

Management advisory agreement (4)

19.0

4.0

8.0

7.0



Total

1,758.5

166.8

318.5

1,205.0

68.2

Holdings:

Long-term debt obligations (5)

564.7

129.8





434.9

Interest on long-term debt (6)

332.9

67.4

122.5

122.6

20.4

Total

897.6

197.2

122.5

122.6

455.3

(1)Includes payment of the term loan and senior notes. Does not include interest payments for estimated future borrowings on the asset-based revolving credit facility.

(2)Includes interest on the outstanding long-term debt of Guitar Center. Future interest on the floating-rate term loan assumes the rate in effect as of December 31, 2012 will remain constant in future periods. Does not include amounts for interest on estimated future borrowing on the asset-based revolving credit facility.

(3)Represents minimum rent payments for operating leases under current terms. Excluded from our operating lease commitments are amounts related to insurance, taxes and common area maintenance associated with leased property and equipment. These amounts have ranged between approximately 34% and 38% of the total lease expense over the previous three years.

(4)Represents minimum fees payable under an advisory agreement with Bain Capital, in effect until October 2017.

(5)Represents principal payments on the senior PIK notes. Includes the principal payment of $129.8 million that we expect to make in April 2013 related to paid-in-kind interest on the senior PIK notes.

We believe that the relatively moderate rates of inflation experienced in recent years have not had a significant impact on our net sales or profitability. However, we have experienced increases in freight and we have also been experiencing increased product costs as the commodity and labor prices in Asia, particularly in China, have been rising.

Off-balance sheet arrangements

We have no off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K that have or are reasonably likely to have a material current or future on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

Critical accounting estimates

We have prepared our consolidated financial statements in conformity with accounting principles generally accepted in the United States. These accounting principles require us to make a number of estimates and assumptions that affect some of the reported amounts. Actual results could differ significantly from those estimates under different assumptions and conditions. We believe the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results and require managements most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Additionally, the policy described below regarding credits and other vendor allowances is unique to our industry and deserves the attention of a reader of our financial statements.

Valuation of inventory

We generally value our merchandise inventory at the lower of weighted average cost method or market value. We value rental inventories and used and vintage guitars at the lower of cost or market using the specific identification method. We depreciate rental inventories on a straight-line basis while out under a rental agreement for rent-to-own sales. We record adjustments to the value of inventory based upon obsolescence and changes in market value. Applicable costs associated with bringing inventory through our Guitar Center retail distribution center are capitalized to inventory. The amounts are expensed to cost of goods sold as the associated inventory is sold. Management has evaluated the current level of inventories considering future customer demand for our products, taking into account general economic conditions, growth prospects within the marketplace, competition, market acceptance of current and upcoming products and management initiatives. Based on this evaluation, we have recorded adjustments to inventory with a corresponding charge to cost of goods sold for estimated decreases in net realizable value. These judgments are made in the context of our customers shifting needs, product and technological trends, and changes in the demographic mix of our customers. A misunderstanding of these conditions could result in inventory valuation changes as of any given balance sheet date.

Valuation of long-lived assets

We evaluate long-lived assets, such as property and equipment and intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We consider the following factors, among other things, to be important indicators of impairment:

For long-lived assets, such as property and equipment and intangible assets with finite lives, we evaluate for impairment by comparing the carrying value of the assets to the estimated undiscounted future cash flows expected to be generated by the assets. If a potential impairment is identified, we recognize an impairment loss for the amount by which the carrying amount exceeds the fair value of the asset. Fair value may be determined based, in part, on appraisal values assessed by third parties, if deemed necessary, or a discounted future cash flows analysis.

We evaluate goodwill and intangible assets with indefinite lives for impairment annually and we evaluate all intangible assets for impairment whenever events or changes in circumstances indicate that the assets may be impaired.

We perform a qualitative assessment annually of each reporting unit that has goodwill to determine if facts and circumstances indicate that goodwill is more likely than not impaired. If the qualitative assessment indicates that goodwill is more likely than not impaired, we perform the quantitative two step goodwill impairment test. If the qualitative assessment indicates that goodwill of a reporting unit does not meet the more-likely-than-not threshold for impairment, we do not perform a quantitative impairment test for the reporting unit.

The quantitative goodwill impairment test is a two-step test. In the first step of the test, we evaluate goodwill for impairment by comparing the estimated fair value of each reporting unit that has goodwill to its carrying value. We estimate the fair value of each reporting unit using a combination of market multiple and discounted cash flow analyses, and comparable transactions whenever possible. If the step one analysis indicates goodwill may be impaired, we perform the second step of the test by allocating the reporting units fair values to its assets and liabilities as if it had been acquired in a business combination. We recognize an impairment loss for the amount by which the carrying amount of goodwill at the reporting unit exceeds the implied fair value of goodwill from the step two analysis.

We perform a qualitative assessment annually of our indefinite-lived intangible asset to determine if facts and circumstances indicate that an asset is more likely than not impaired. If the qualitative assessment indicates that an indefinite-lived intangible asset is more likely than not impaired, we compare the fair value of the intangible asset to its carrying amount. We recognize an impairment loss for the amount by which the carrying amount of the intangible asset exceeds its estimated fair value. The estimated fair values of trademarks with indefinite lives are also determined using a discounted cash flow analysis.

For the undiscounted and discounted cash flow analyses used in our impairment tests, we use estimates and assumptions that we consider reasonable in relation to the plans and estimates used to manage our business. We also consider assumptions that we believe market participants would use in pricing the assets and liabilities. Significant judgment is required in selecting those assumptions, such as discount rates, growth rates, terminal capitalization rates and market multiples. We consider current and future expected sales volumes and related operating costs and any anticipated increases or decreases based on expected market conditions and local business environment factors. Significant management judgment is required in the forecasts of future operating results that are used in both undiscounted and discounted impairment tests. It is possible that our plans may change and estimates may prove to be inaccurate. If actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur additional impairment charges.

See the notes to the consolidated financial statements included elsewhere in this annual report for further discussion of impairment of goodwill and other intangible assets.

Self-Insurance reserves

We maintain a self-insurance program for workers compensation of up to $500,000 per claim and medical insurance of up to $400,000 per claim. Excess amounts are covered by stop-loss insurance coverage, subject to an aggregate annual deductible of $100,000 for medical insurance claims. We recognize a liability for the undiscounted estimated ultimate cost of claims that are known, claims that are incurred but not reported and defense costs. Our self-insurance reserves are based on an actuarial analysis of historical experience and trends in paid and incurred claims.

As part of our satisfaction guaranteed policy, we allow Guitar Center customers to return product generally within 30 days after the date of purchase, and we allow our direct response segment customers to return products within 45 days. Music & Arts customers have 30 days from the date of purchase to return products. We may also extend these return periods on an exception basis to accommodate customer returns for holiday season sales. We regularly review and revise, when deemed necessary, our estimates of sales returns based upon historical trends. While our estimates during the past few years have approximated actual results, actual returns may differ significantly from our estimates, either favorably or unfavorably, if factors such as economic conditions or the competitive environment differ from our expectations.

Credits and other vendor allowances

We receive cooperative advertising allowances (allowances from the manufacturer to subsidize qualifying advertising and similar promotional expenditures we make relating to the vendors products), price protection credits (credits from vendors with respect to in-stock inventory if the vendor subsequently lowers its wholesale price for such products) and vendor rebates (credits or rebates provided by vendors based on the purchase of specified products and paid at a later date).

We recognize cooperative advertising allowances as a reduction to selling, general, and administrative expense when we incur the advertising expense eligible for the credit.

We account for price protection credits and vendor rebates as a reduction of the cost of merchandise inventory. We record these credits and rebates at the time the credit or rebate is earned. We recognize the effect of price protection credits and vendor rebates as a reduction of cost of goods sold at the time the related inventory is sold. We reserve for the portion of vendor rebates we estimate will be uncollectible. We estimate the portion of vendor rebates that will be uncollectible through an aging review, specific identification and an analysis of vendor relationships. None of these credits are recorded as revenue.

Gift cards

We sell gift cards to our customers through our two gift card subsidiaries. Revenue from gift card sales is recognized upon redemption of the gift card. Other than a limited number of promotional gift cards, our gift cards do not have expiration dates. Based on historical redemption rates, a certain percentage of gift cards will never be redeemed, which we refer to as breakage. Estimated breakage income is recognized as the remaining gift card values are redeemed and is recorded as a reduction of cost of goods sold.

Recently issued accounting pronouncements

See Note 1 in the combined notes to consolidated financial statements included in this annual report for a description of recently issued and adopted accounting pronouncements, including the dates of adoption and impacts on our results of operations, financial position and cash flows.

We do not expect the adoption of recently issued accounting pronouncements to have a significant impact on our financial position, results of operations or cash flows.

We have market risk exposure arising from changes in interest rates on our term loan credit facility. The interest rates on our term loan facility reprice periodically, which will impact our earnings and cash flow.

A 1% increase in the floating interest rate on our term loan would result in approximately $6 million additional interest expense per year.

We are also exposed to interest rate risk on our variable rate asset-based revolving credit facility. Historically, we have not had material interest rate exposure on this credit facility as our borrowings have been in small amounts or for short time periods. We expect our usage of this credit facility to increase in 2013 and future years and our interest rate risk exposure will increase accordingly.

We do not anticipate hedging our interest rate risk on the term loan or the asset-based revolving credit facility in the near term. For the period from January 2008 to January 2013, we had hedged a portion of our interest rate risk on the term loan using interest rate cap agreements; these derivative instruments matured in December 2012 and January 2013.

The interest rates on our senior notes and senior PIK notes are fixed.

Item 8. Consolidated Financial Statements and Supplementary Data

The Consolidated Financial Statements and Supplementary Data are included as an annex to this annual report and incorporated herein by reference. See the Index to Consolidated Financial Statements and Supplementary Data on page F-1.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures

Evaluation of Disclosure Controls and Procedures (for each of Holdings and Guitar Center)

We maintain disclosure controls and procedures (as defined in Rule 13a-15(e) or Rule 15d-15(e) promulgated under the Securities Act of 1934, as amended, or the Exchange Act, that are designed to provide reasonable assurance that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable, and not absolute, assurance of achieving the desired control objectives. In reaching a reasonable level of assurance, management necessarily was required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures.

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation prior to filing this report of our disclosure controls and procedures. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of December 31, 2012.

Managements Annual Report on Internal Control over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 3a-15(f) and 15d-15(f) under the Exchange Act. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements and can provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may deteriorate.

Management assessed the effectiveness of the Companys internal control over financial reporting as of December 31, 2012. Management based this assessment on the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control  Integrated Framework.

Based on its assessment, management concluded that, as of December 31, 2012, the Companys internal control over financial reporting is effective.

Changes in Internal Control over Financial Reporting (for each of Holdings and Guitar Center)

There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during 2012 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Item 9B. Other Information

There was no information required to be disclosed in a Current Report on Form 8-K during the fourth quarter of the year covered by this Annual Report on Form 10-K that was not reported.

Executive officers and directors of Guitar Center are set forth below. Information regarding the management of Holdings is listed in the executive background descriptions below.

Name

Age

Position

Martin Hanaka

63

Interim Chief Executive Officer and Director

John Bagan

48

Executive Vice President, Merchandising

Dennis Haffeman

60

Executive Vice President, Human Resources

Frank Hamlin

44

Executive Vice President, E-Commerce and Marketing

Eugene Joly

59

Executive Vice President, Stores

Tim Martin

44

Executive Vice President, Chief Financial Officer

Erick Mason (a)

48

Executive Vice President, Chief Strategic Officer

Kenny OBrien

57

Chief Executive Officer, Music & Arts

Stephen Zapf

47

President, Music & Arts

Marty Albertson

59

Non-Executive Chairman and Director

Jordan Hitch

46

Director

Matthew Levin

46

Director

Lew Klessel

45

Director

Tom Stemberg

64

Director

(a)In March 2013, we announced that Mr. Mason had notified us of his intention to resign from his positions with Guitar Center and Holdings effective at the beginning of April.

With respect to our current directors, Messrs. Hitch, Levin, Klessel and Stemberg are affiliates of Bain Capital or its co-investors and Mr. Albertson is our former Chief Executive Officer. Mr. Hanaka was appointed in January 2013 to serve as a member of the Board of Directors and as interim Chief Executive Officer, filling a vacancy in the Board of Directors created by the departure of Gregory Trojan in October 2012. Directors are chosen by Bain Capital based on their general business experience and their experience working with other private equity owned companies or other retailers (as further detailed in the biographies below). Our board has not determined any of our directors to be independent under the standards adopted by the New York Stock Exchange or the NASDAQ Stock Market, which do not apply to us as a privately held corporation.

The principal occupations and positions for at least the past five years of the executive officers and directors named above are as follows:

Martin Hanaka. Mr. Hanaka joined Guitar Center in January 2013 as our Interim Chief Executive Officer. Mr. Hanaka was Advisor of Golfsmith International Holdings, Inc. in November and December 2012 and previously served as a director and Chairman of the Board of Directors of Golfsmith International Holdings, Inc. from April 2007 to November 2012, Chief Executive Officer from June 2008 to November 2012 and President from June 2008 to February 2012. As a result of these and other professional experiences, Mr. Hanaka brings to our board deep knowledge of and expertise in finance, corporate strategy development and leading complex organizations, which strengthen the collective qualifications, skills and experience of our Board of Directors.

John Bagan. Mr. Bagan joined Guitar Center in June 2008 as Executive Vice President, General Merchandising Manager. In January 2011, Mr. Bagan became Executive Vice President, Chief Merchandising Officer. From 2002 to September 2006, Mr. Bagan served in a variety of roles at Albertsons, a national supermarket and drug store chain, the last of which was Vice President HBC/GM Merchandising with responsibility across their grocery and drug channels. Mr. Bagan was not employed from October 2006 to May 2008. Prior to Albertsons, Mr. Bagan held a variety of positions with increasing levels of responsibility at Morgan Stanley, American Stores and Target.

Dennis Haffeman. Mr. Haffeman joined Guitar Center in 2004 and currently serves as Executive Vice President, Human Resources. Mr. Haffeman has held a number of positions in Guitar Centers retail and corporate operations during his tenure at the company. Mr. Haffeman was on the Transitional Leadership Team at Best Buy from 2001 to 2004. Prior to that time, Mr. Haffeman served as the Chief Merchant and then Vice President of Stores and Operations for Mars Music and held senior leadership positions at Office Depot and Best Products.

Frank Hamlin. Mr. Hamlin joined Guitar Center in June 2010 as Executive Vice President, GM, E-Commerce and Marketing. In January 2011, Mr. Hamlin became Executive Vice President, Guitar Center Brands and beginning in July 2012, Mr. Hamlin also assumed responsibility for managing our direct response brands. From 2007 to May 2010, Mr. Hamlin was Executive Vice President Chief Operating Officer of E-Miles, LLC, an interactive marketing company. From 2004 to 2007, he was Director of Marketing, Central Market Division for H.E. Butt Grocery, a fresh, specialty and prepared foods retailer. Prior to that time, Mr. Hamlin held various positions with Brierly & Partners, E-Rewards, Arista Records and The Walt Disney Company.

Eugene Joly. Mr. Joly joined Guitar Center in October 2002 as Vice President of High Tech Merchandising and was promoted to Senior Vice President in 2004, to Executive Vice President of Merchandising of the Musicians Friend division in September 2007 and to Executive Vice President of Stores in September 2008. Mr. Joly served as Vice President and General Manager of the TASCAM division of TEAC America from 1998 to 2002 and prior to that held senior leadership positions at several musical instrument retailers.

Tim Martin. Mr. Martin joined Guitar Center in October 2012 as our Executive Vice President and Chief Financial Officer. From December 2009 to July 2012, Mr. Martin was the Chief Financial Officer of Lands End, a division of Sears Holdings Corporation and a leading direct merchant of family apparel and accessories and home products. Mr. Martin was previously employed at Coldwater Creek, Inc., a multi-channel specialty retailer of womens apparel, gifts, jewelry and accessories, serving as Vice President of Finance and Chief Accounting Officer from August 2006 to August 2007 and as Chief Financial Officer from September 2007 to November 2009. Prior to that, Mr. Martin served as Chief Accounting Officer and as Vice President of Finance/Global Commercial Operations for Amgen Inc., a pharmaceutical company, from August 2003 to May 2006. Mr. Martin also serves as Vice President and Assistant Secretary of Holdings.

Erick Mason. Mr. Mason joined Guitar Center in 1996 as our corporate controller. In January 1999, Mr. Mason was promoted to Senior Vice President, Finance, and in May 2001, Mr. Mason became our Senior Vice President of Operations and Finance. In March 2003, Mr. Mason was promoted to Executive Vice President and Chief Administrative Officer. In April 2006, Mr. Mason became our Chief Financial Officer. In October 2012, Mr. Mason became our Chief Strategic Officer, with responsibility to oversee strategic planning, supply chain, real estate, legal and information technology operations. From 1986 to 1996, Mr. Mason was employed by KPMG LLP, most recently as senior manager. Mr. Mason also serves as Vice President and Assistant Secretary of Holdings. In February 2013, Mr. Mason notified us of his intention to resign from his positions with Guitar Center and Holdings effective at the beginning of April.

Kenny OBrien. Mr. OBrien has been the Chief Executive Officer of Music & Arts since 1988, including the time since 2005 when Music & Arts was acquired by us.

Stephen Zapf. Mr. Zapf joined Musicians Friend in 2006 as Executive Vice President, Marketing. In January 2010, Mr. Zapf became Executive Vice President, Multichannel and after briefly leaving Guitar Center from July to October 2012, Mr. Zapf was appointed President of Music & Arts in November 2012. Prior to Musicians Friend, Mr. Zapf was the Chief Operating Officer of DBI, Inc. after its merger in 2002 with Music123.com, where Mr. Zapf was founder and served as Chief Executive Officer & President. Mr. Zapf began his career with McKinsey and Company.

Marty Albertson. Mr. Albertson joined Guitar Center in 1979. Mr. Albertson joined Guitar Center as a salesperson and has held various positions of increasing responsibility with Guitar Center since that time. From 1990 to 1999, Mr. Albertson served as our Executive Vice President and Chief Operating Officer. In 1999, Mr. Albertson became our President and Co-Chief Executive Officer. In 2004, Mr. Albertson became our Chairman of the Board and Chief Executive Officer. Mr. Albertson retired as our Chairman of Board of Directors and Chief Executive Officer in November 2010, at which time he became Non-Executive Chairman of the Board of Directors. Mr. Albertson was elected a director in 1996. Mr. Albertson also serves as a director and Non-Executive Chairman of the Board of Directors of Holdings. As a result of these and other professional experiences, Mr. Albertson possesses particular knowledge of our business, including our customers, suppliers, employees and other stakeholders, which strengthens the collective qualifications, skills and experience of our Board of Directors.

Jordan Hitch. Mr. Hitch is a Managing Director at Bain Capital, a position he has held since January 2005. Mr. Hitch joined Bain Capital in 1997 as an Associate and became a Principal in January 2006. Prior to joining Bain Capital, Mr. Hitch was with Bain & Company from 1995 to August 1997, Mr. Hitch serves on the board of directors of Bombardier Recreational Products, Gymboree Corp., Bright Horizons Family Solutions and Burlington Coat Factory. Prior to joining the firm, Mr. Hitch was a consultant at Bain & Company where he worked in the financial services, healthcare and utility industries. Mr. Hitch also serves as a director and Vice President of Holdings. As a result of these and other professional experiences, Mr. Hitch brings to our board significant experience in and knowledge of corporate finance and strategy development, which strengthen the collective qualifications, skills and experience of our Board of Directors.

Matthew Levin. Mr. Levin is a Managing Director at Bain Capital, a position he has held since 2000. Mr. Levin joined Bain Capital in 1992. Mr. Levin serves on the board of directors of Bombardier Recreational Products, Dollarama, Michaels Stores, Toys R Us, Edcon Holdings (Pty) Ltd., Lilliput, Inc. and Unisource. Prior to joining the firm, Mr. Levin was a consultant at Bain & Company where he consulted in the consumer products and manufacturing industries. Mr. Levin also serves as a director and Vice President of Holdings. As a result of these and other professional experiences, Mr. Levin brings to our board significant experience in and knowledge of corporate finance and managing companies in industries similar to ours, which strengthen the collective qualifications, skills and experience of our Board of Directors.

Lew Klessel. Mr. Klessel is a Managing Director at Bain Capital, a position he has held since December 2011. Mr. Klessel joined Bain Capital in October 2005 as an Executive Vice President. Prior to joining Bain Capital, Mr. Klessel held several senior operating positions with Home Depot from 1997 to September 2005, including President of HD Supplys Facilities Maintenance business, Divisional Merchandise Manager and head of Home Depots Strategic Business Development function. Prior to 1997, Mr. Klessel was a strategy consultant with McKinsey & Company and a senior auditor with Ernst & Young. Mr. Klessel serves on the board of directors of HD Supply, Inc. and Michaels Stores. Mr. Klessel also serves as a director and Vice President of Holdings. As a result of these and other professional experiences, Mr. Klessel brings to our board extensive experience in and knowledge of operating and managing complex organizations, particularly in the retail industry, which strengthen the collective qualifications, skills and experience of our Board of Directors.

Tom Stemberg. Mr. Stemberg has been a Managing General Partner at Highland Consumer Fund, an equity co-investor in connection with the Transactions, since November 2006. Mr. Stemberg joined Highland Consumer Fund in May 2005 as a venture partner. Prior to joining Highland, Mr. Stemberg founded Staples and served as its Chief Executive Officer for sixteen years until February 2002 and Chairman of the Board of Directors for three additional years until June 2005. Mr. Stemberg currently serves on the board of directors of CarMax, Inc., lulumonahtletica, PETsMART, Inc., Pharmca, City Sports and StriVectin. As a result of these and other professional experiences, Mr. Stemberg brings to our board deep knowledge of and expertise in finance, corporate strategy development and leading complex organizations, which strengthen the collective qualifications, skills and experience of our Board of Directors.

The Board of Directors of Holdings is responsible for governing our business and affairs. As Holdings is privately held and the members of the Board of Directors are selected by Bain Capital, the board does not maintain policies and procedures by which stockholders may submit director candidates to the board or the stockholders for consideration. Highlights of our corporate governance practices are described below.

Board Committees

Currently, the Board of Directors of Holdings has two active standing committees.

Audit Committee

Lew Klessel is currently the sole member of the Audit Committee. The board has determined that the Audit Committee member is financially literate and has sufficient business and financial expertise to effectively perform his duties as a member of the Audit Committee. As Holdings is privately held and controlled by Bain Capital, the board has determined that it is not necessary to designate one or more of the Audit Committee members as an audit committee financial expert at this time. Mr. Klessel is not an independent director due to his affiliation with Bain Capital.

Under its charter, the Audit Committee is generally responsible for overseeing our financial reporting process and assists the board in fulfilling the boards oversight responsibilities with respect to: (i) the integrity of our financial statements; (ii) our compliance with legal and regulatory requirements; (iii) the qualifications and independence of our independent registered public accounting firm; and (iv) the performance of the independent registered public accounting firm and of our internal audit function.

Compensation Committee

Please see Item 11. Executive Compensation-Compensation Discussion and Analysis for a description of the roles and responsibilities of the Compensation Committee.

Code of Business Conduct and Ethics

We have adopted a Code of Business Conduct and Ethics that applies to, among others, our principal executive officer, principal financial officer, and principal accounting officer or controller, or persons performing similar functions.

Item 11. Executive Compensation

Compensation Discussion and Analysis

This Compensation Discussion and Analysis provides information about the objectives and elements of our compensation philosophy, policies and practices with respect to the compensation of our executive officers who are listed in the Summary Compensation Table set forth below, which we refer to as our named executive officers.

The Compensation Committee of the Board of Directors of Holdings is comprised of Jordan Hitch and Matthew Levin. Both Mr. Hitch and Mr. Levin are affiliated with Bain Capital, our sponsor. As a result, none of the members of Compensation Committee has been deemed to be an independent director.

Compensation Program

Our philosophy in establishing compensation policies for our officers and executive officers, including our named executive officers, is to align compensation with our strategic goals and our sponsors growth objectives, while concurrently providing competitive compensation that enables us to attract and retain highly qualified executives. The principal guiding objectives of our compensation policies are to:

Currently, the total compensation for our officers and executive officers, including our named executive officers, consists of three main components: base salary, annual cash incentive bonuses and long-term equity-based incentive compensation awards. We strive to reward exceptional corporate and financial performance with higher annual cash compensation. While the Compensation Committee takes into account tax and accounting considerations in structuring the components of our compensation program, these considerations are secondary to the primary objectives described above.

Compensation Strategy

The Compensation Committee, in consultation with the Board of Directors and our Chief Executive Officer (other than with respect to his own compensation), is responsible for determining the compensation of all executive officers, including our named executive officers.

The compensation for officers below the executive officer level is typically established by our Chief Executive Officer, in consultation with the Compensation Committee.

To determine compensation levels for the executive officers, the Compensation Committee considers principally the consolidated financial performance of our company, including the achievement of financial and strategic initiatives. An executive officers compensation level relative to other executive officers is also influenced by that officers position and related responsibilities, length of service to our company and prior employment experience. For example, the total compensation of our former Chief Executive Officer and our interim Chief Executive Officer is greater than that of other current executive officers due to their leadership in setting overall strategic goals and considerable past experience as a chief executive. The compensation for Mr. Martin, our Chief Financial Officer, reflects his role in managing and leading our financial and accounting systems and his past experience in our industry fulfilling that role. The compensation for Mr. Mason, our Chief Strategic Officer, reflects his role in providing leadership for our technology, logistics and real estate functions and his more than 15 years of service to our company. The compensation for Mr. Joly, the Executive Vice President of Stores, reflects his role in directing the operations of our retail stores and his more than 10 years of service to our company. The compensation for Mr. OBrien, the Chief Executive Officer of our Music & Arts business, reflects his more than 20 years of service to that business and his leadership of an important business segment. The compensation for Mr. Hamlin, the Executive Vice President responsible for our Guitar Center and direct response brands, reflects his role in directing the marketing and branding for our major brands.

The Compensation Committee also considers overall past compensation and incentives and seeks to appropriately motivate executives to achieve high levels of company performance. The Compensation Committee, through its members involvement in numerous other of our sponsors portfolio companies, has access to compensation-related information that serves to build our overall compensation program for employees generally, and for executive officers in particular.

To date, we have not formally benchmarked our executive compensation against peer companies, nor have we identified a group of peer companies which would be included in a benchmarking survey. Compensation amounts historically have been highly individualized and discretionary, based largely on the collective experience and judgment of our Compensation Committee members, along with input from our Chief Executive Officer and other executive officers, as appropriate. While our Compensation Committee considers the overall mix of compensation components in its review of compensation matters, it has not adopted any policies or guidelines for allocating compensation between long-term and short-term compensation, between cash and non-cash compensation or among different forms of non-cash compensation. Approvals by the Compensation Committee are therefore predominantly based on the experience of the members of the Compensation Committee and alignment with our overall strategic direction and goals.

Base salaries for our named executive officers are generally established at what the Compensation Committee believes are competitive levels based on the members experience and knowledge of compensation paid by similar companies for similar positions and considering the scope of the individuals responsibilities, individual performance and prior experience, our operating and financial performance and the achievement of planned financial and strategic initiatives. The Compensation Committee sets base salaries at levels designed to attract and retain highly qualified individuals able to drive our financial performance and meet strategic goals. Base salaries are reviewed and adjusted annually as deemed appropriate by the Compensation Committee, but adjustments may occur at any time during a year at the discretion of the Compensation Committee.

The following table sets forth annual base salaries as of the end of 2012 and 2011 for our named executive officers:

Base Salary

2012

2011

Tim Martin (1)(2)

$

425,000

$



Erick Mason (2)

$

423,500

$

400,000

Frank Hamlin

$

373,300

$

335,000

Eugene Joly (2)

$

372,000

$

350,000

Kenneth OBrien

$

393,460

$

382,000

Gregory Trojan (3)

$

887,000

$

850,000

(1)Mr. Martin joined the company in October 2012.

(2)Each of Mr. Joly, Mr. Martin and Mr. Mason also received a temporary salary increase in the amount of $50,000 per quarter for serving as a member of the Office of the Chief Executive, prorated for the period from October 29, 2012 to December 31, 2012.

(3)The base salary of Mr. Trojan reflects his base salary as of the date of his resignation in November 2012.

The base salary actually earned by each of our named executive officers is listed below in the Summary Compensation Table.

In 2012, the Compensation Committee approved the executive bonus plan to provide financial incentives to executive officers and other members of management who are in a position to drive our financial performance and meet strategic goals.

Under the executive bonus plan, each named executive officer has an annual incentive target expressed as a percentage of base salary. Each named executive officers annual incentive award is based on EBITDA results for the enterprise or one or more of our business units, as well as an individual performance component. We believe that this methodology of determining the financial performance component of the annual bonus closely aligns the named executive officers interests with our stockholders interests, as it is a measure used in calculating financial ratios in several debt covenants in our asset-based credit facility and term loan and we believe it is an accurate indicator of our financial performance. We calculate EBITDA, for this purpose, as earnings (loss) before interest, tax, depreciation and amortization with certain adjustments.

Accordingly, each named executive officer was entitled to a bonus of up to a certain percentage of that executive officers base salary. The Compensation Committee sets the threshold, target and maximum performance levels for all of the executive officers. The final award depends upon the actual level of performance achieved. The Compensation Committee, however, retains the right to make adjustments in its sole discretion. The target levels of performance for the bonus goals were set at levels that the Compensation Committee believed to be reasonably achievable in view of our historical annual performance.

The following table sets forth bonus targets and performance weightings for 2012:

Erick Mason

Frank Hamlin

Eugene Joly

Kenneth OBrien

Gregory Trojan

Target Bonus

Percentage of base salary

75%

50%

50%

75%

100%

Performance target weightings

Adjusted EBITDA

Company

80%

80%

80%

80%

Music & Arts

60%

Free Cash Flow

Music & Arts

20%

Individual performance

20%

20%

20%

20%

20%

Total

100%

100%

100%

100%

100%

Mr. Martin was hired as our Chief Financial Officer effective October 1, 2012 and his bonus was set pursuant to his offer of employment.

For 2012, the Compensation Committee established target levels for bonuses, with threshold bonuses beginning at 94% of target, and maximum bonuses being obtained at 120% of target.

The following tables set forth the bonus performance targets and achievement in 2012:

Company

Music & Arts

Adjusted EBITDA

Target (in millions)

$

232.0

$

23.0

Percentage of target achieved

86.2

%

91.4

%

Percentage of target bonus target earned

0

%

0

%

Free Cash Flow

Target (in millions)

$

14.0

Percentage of target achieved

91.5

%

Percentage of target bonus earned

0

%

Erick Mason

Frank Hamlin

Kenneth OBrien

Eugene Joly

Gregory Trojan

Individual performance

(1)

20%

20%

20%

(2)

(1)In connection with Mr. Masons departure from the company, he will receive payments in accordance with the terms of his severance agreement.

(2)Mr. Trojan did not receive a bonus in connection with his departure from the company in November 2012.

Actual bonus amounts earned by our named executive officers for 2012 are listed below in the Summary Compensation Table.

Long-Term Equity-Based Compensation

Our long-term incentive awards have primarily been in the form of stock options granted under the Guitar Center Holdings, Inc. 2009 Amended and Restated Management Equity Plan, which we refer to as the option plan, which was adopted by the Board of Directors on November 18, 2009. The option plan allows for the grant of non-qualified stock options and non-qualified rollover options, which are options granted before the original effective date of the option plan in connection with the contribution of equity by the executive officers in connection with the Transactions.

We have used grants of stock options as our principal form of equity incentive because we believe stock options are an effective means to align the long-term interests of our executive officers with those of our stockholders. The options attempt to achieve this alignment by providing our executive officers with equity incentives that vest over time or upon the occurrence of certain events. The value of an option is at risk for the executive officer and is entirely dependent on the value of a share of our stock. The value of our stock is dependent in many ways on managements success in achieving our goals. If the price of our common stock drops, for any reason, over the vesting period of the option, the value of the option to the executive will drop and could become worthless.

The size of each option award is intended to offer the executive a meaningful opportunity for stock ownership relative to his or her position and reflects our Compensation Committees assessment of market conditions affecting the position as well as the individuals potential for future responsibility within our company. Awards are generally granted in the year that an executive officer commences employment. Additional options may be granted in the discretion of the Compensation Committee. The size of option grants is determined by the Compensation Committee, typically based on the recommendation of our Chief Executive Officer (except with respect to his own option grants). Options granted to our named executive officers in 2012 are listed below in the Summary Compensation Table and the Grants of Plan-Based Awards table.

We may in the future grant other forms of equity incentives, subject to the Compensation Committees discretion, to ensure that our executives are focused on long-term value creation.

The following is a summary of the material terms of the option plan, but does not include all of the provisions of the option plan. For further information about the option plan, we refer you to its complete copy filed as an exhibit to our registration statement on Form S-4, as filed with the SEC on June 30, 2011.

Administration. The option plan is currently administered by our Compensation Committee.

Available Shares. Under the option plan, the Compensation Committee may authorize awards consisting of rollover options in such numbers of shares as it may determine from time to time. An aggregate of no more than 1,102,500 shares of the common stock of Holdings are reserved for issuance of options other than rollover options, plus an additional number of options issued as replacement options for rollover options under the rollover program described below.

Eligibility for Participation. Our officers, directors, employees, consultants and advisors are eligible to receive awards under the option plan.

Options. Unless otherwise provided in an award agreement, options granted under the option plan have a ten year contractual term and are divided into three equal tranches. Each tranche is subject to a five-year service-based vesting period with 20% vesting on each anniversary date based on the original grant date. The vesting of tranche 3 awards is also dependent on achievement of performance- and market-based vesting conditions, requiring the realization in a liquidity event of an investment return equal to one and one-half times the investment by Bain Capital, or approximately $900 million based on an investment of approximately $600 million. Tranche 3 awards are only deemed fully vested when they have both time vested and performance vested. As of December 31, 2012, all outstanding tranche 1 and 3 awards have an exercise price of $63.00 per share and all outstanding tranche 2 awards have an exercise price of $31.50 per share. As of December 31, 2012, there were also 13,610 fully vested stock option awards outstanding with an exercise price of $26.26 per share. These awards are not subject to the service or performance- and market-based vesting conditions of other awards granted under the plan.

The plan provides for accelerated vesting of unvested stock options if there is a change in control, as defined in the option plan, or if Bain Capital fails to own at least 10% of our aggregate common stock after an initial public offering. However, no named executive officer would have received a payment or benefit as a result of this provision if a change in control had occurred as of December 31, 2012 because the value of our common stock did not exceed the exercise price of options held on that date.

The size of each award was based on each named executive officers position and the total target compensation packages deemed appropriate for such positions. The Compensation Committee believes these awards were reasonable and consistent with the nature of the individuals responsibilities and satisfied the goals of competitive compensation and the retention of key executive officers.

Rollover options. The Compensation Committee issued options as consideration for the agreement of the respective participant to forgo the exercise of options issued by subsidiaries of Holdings prior to the original effective date of the option plan in connection with the Transactions in 2007. We refer to these options as rollover options. However, the Compensation Committee has discretion to determine the quantity, price and the terms and conditions of future awards of rollover options.

Options that were granted on June 1, 2011 were replacement awards for rollover options. During 2010, all outstanding rollover options, with exercise prices ranging from $15.31 to $15.75, were exercised in a cashless exercise, whereby shares were surrendered to satisfy the exercise price. Concurrently with the cashless exercise, new options were granted to replace the surrendered options. A portion of the outstanding shares related to the 2010 cashless exercise of rollover options were repurchased in June 2011 and new options were granted to replace the repurchased shares. The replacement options were fully vested with a contractual term of ten years from the grant date of June 1, 2011, and had an exercise price of $24.17, which was equal to the estimated fair value of our common stock on the grant date.

Outstanding rollover options as of December 31, 2012 had exercise prices ranging from $22.82 to $24.17.

Other Benefits and Perquisites

Our named executive officers also receive various other benefits and perquisites. During 2012, these benefits included company-paid medical benefits and either a car allowance or the eligibility to participate in our company provided car program. The Compensation Committee and the Board of Directors believe these benefits and perquisites are reasonable and consistent with the nature of our named executive officers responsibilities, provide a competitive level of total compensation to our executives and serve as an important element in retaining those individuals.

Compensation Committee Report

The Compensation Committee of the Board of Directors of Holdings has responsibility for determining the compensation of our named executive officers. The Compensation Committee has reviewed and discussed the Compensation Discussion and Analysis with management and, based on such review and discussion, the Compensation Committee recommended to the Board of Directors of Holdings that the Compensation Discussion and Analysis be included in this Annual Report on Form 10-K for the year ended December 31, 2012 and such other filings with the SEC as may be appropriate.